Targeted businesses or investments frequently use discounted cash flow analysis to determine the value of the company and investment, and this remains one of the most common research-driven valuation methods. It is a retrospective based method that teaches investors, analysts and business owners to identify the value today of expected future cash flows. However there is one essential component that accounts for most of this value, the terminal value calculation.
Whether you are a start-up founder pitching an investor meeting, a financial analyst evaluating an acquisition target, or a CFO assessing ideas for long-term capital budgeting, grasping the DCF terminal value is a fundamental aspect of constructing a valuation model that is accurate and credible.
Now, let us get into the details of what is the terminal value calculation, its importance and how to nail it with confidence.
Understanding Terminal Value in Discounted Cash Flows
In a DCF, we calculate the present value of a business by forecasting its free cash flows for an explicit forecast period (typically between 5 and 10 years). Yet, no business stops cash generative after the length of the forecast is over. And that is what terminal value helps with.
The terminal value is the value of all future cash flows when a business has an infinite life, which are beyond the number of cash flows you are explicitly forecasting. It serves as a surrogate of the value of the business at the end of the projection horison, discounted back to the present, representing the value of its ongoing operations, in perpetuity (or some other longer-term period).
Why Terminal Value Matters
With most mature companies, or more stable investments, the terminal value typically accounts for 60% to 80% and sometimes more of the total discounted cash flow analysis value. We have always said it is a large part of the credibility of valuations as a whole.
- Fills the void: In the event that you’re modelling a long-term business, you’re not going to want to be forecasting every single year of future cash flows.
- Makes it more realistic: Investors will expect a business to be operating and returning profits long after five or ten years.
- Impacts on Negotiation Results: The estimated terminal value is highly sensitive, in particular since the slightest change in terminal value calculation will lead to astronomical changes in company value in the M&A, fundraising or equity pricing context.
Two Primary Approaches to Terminal Value
Generally, there are two primary approaches you can take when performing a terminal value calculation. We are not going to get into the formulas here, but you need to understand the logic behind each.
Perpetuity Growth Method (Gordon Growth)
This approach assumes the business will generate cash flows that are growing at a steady, constant growth rate indefinitely. This is particularly helpful when valuing stable/mature companies with a predictable earnings base.
- Commonly used in conservative valuations.
- Assumes a perpetual growth rate (often approximate to inflation or GDP growth)
- It is most commonly seen in situations where a business has stable prospects for producing cash flow.
Exit Multiple Method
This approach analyses terminal value via market comparable, applying a financial multiple (EBITDA or EBIT multiple) calculated against comparable companies, which would be similar companies.
- Handy for M&A or private equity settings.
- Based on market trends and comparable company analysis
- Crucially subject to market and sector sentiment
And each comes with its assumptions, risks, and limitations so both can put you off-balance if you are not careful. This is then followed by another question that would be: How do I go about this? The answer to this can best be achieved only once you have an understanding of how the business finally operates, how fast it is going to grow, and into what market it is going to grow to; only then would be able to decide on this method.
Key Assumptions That Influence Terminal Value
However, be careful when estimating it as the assumptions have a massive influence on the DCF terminal value. Each assumption compounds — and each compounding is an input into your sum.
- Terminal growth rate: Select a reasonable terminal growth rate consistent with economic conditions and level of business maturity
- Discount Rate: The risk of future cash flows if you use a higher discount rate, it will decrease the value of those cash flows (which means a lower terminal value)
- Market comparable / sector multiples: if using the exit multiple method, these ideally should be reflective of market conditions at the time of the analysis and relevant to the company in our model.
Problems with Terminal Value
Estimation of terminal value is difficult even for experienced financial analysts. It is one of the largest inputs in the complete DCF valuation, so if not careful, it comes with risk.
- Heavy terminal value: Beware if terminal value accounts for more than 90% of your valuation as that likely indicates unrealistic expectations or mis-estimation.
- Assumptions about growth that are overly ambitious: more than a few errors are a function of modelling growth in a manner that is clearly not sustainable beyond the forecast horison.
- Market volatility: Since exit multiples base on market conditions, comparable can be skewed and the terminal value can be either inflated or deflated disproportionately.
Validating Your Terminal Value
Not to mention, that experienced professionals often validate the terminal value calculation through different perspectives, not just via a spreadsheet.
- Scenario Analysis: Test the assumptions with alternative market and economic scenarios.
- Back into the terminal value: What does terminal value imply in terms of implied valuation multiples—are they consistent with market averages?
- Industry Benchmarking: Compare outputs to real-life exit valuations or public comps
Practical Applications in Business and Finance
DCF terminal value is not a topic that belongs only to investment banker or equity researcher. It is applicable across several business contexts:
- Startup fundraising: Founders use terminal value to justify future growth potential and valuation multiples during venture capital pitches.
- Portfolio company valuations: Investors use terminal value to predict IRR when exiting an investment.
- Corporate finance decisions: CFOs often employ discounted cash flow analysis using a terminal value to assess capital investments and long-term strategic projects.
When it comes to IPO pricing, the logic of terminal value formula is used by investment analysts to justify the entry price on public markets.
Tips for Mastering Terminal Value Estimation
So, how about cementing your knowledge of the terminal value detuning? Here are some of those best practices:
- Stick to conservative growth assumption: Follow macroeconomic trends unless supported by evidence of above macroeconomic growth.
- Re-evaluate all assumptions and inputs: Small changes in projections can swing values wildly.
- Blend methods when in doubt: Sometimes taking the average between the perpetuity growth and exit multiple — yields a relatively depending result.
- Document your logic: Be clear about why you have made each assumption in your valuation model.
A real-world example
Assume you are doing a valuation of a logistics tech company. You have five years of cash flows projected down to amasing detail, but the firm’s value in reality is in its sustainable, scalable model over a longer term period. Your calculation for terminal value accounts for 70% of DCF total by assuming a reasonable growth rate and a reasonable discount rate.
And all of a sudden, a potential investor challenges your valuation. Using both the DCF terminal value method, as well as actual comparable you can point to from similar exits, you add credibility to your valuation and strengthen your argument.
The importance of Accuracy and Integrity
The terminal value equation will seem like just another number in a spreadsheet but has reputational ramifications. If terminals are inflated, it is asking for trouble with suspicion from investor, due diligence failures or even litigation.
On the other side, if an entity undervalues it, the outcomes will be missed opportunities and undercapitalised ventures. Mastery is knowing more than how to calculate it, but how to justify it with logic and foresight.
Conclusion
Terminal value calculation is one of the must-have skills for anyone who is serious about business valuation, investment analysis, or strategic decision-making. It is the intersection of finance and long-termism merging numbers with assumptions, accuracy with opportunity.
A well-constructed DCF is not just a financial model it tells the story of the future of an entire company, based on a rational approach and vision. Once you know the DCF terminal value, you can tell that story in a way that only numbers can do, but numbers that are accepted for the present and for the short and long term.
FAQs
Why is a terminal value important to a DCF?
Terminal value is also an important component in a discounted cash flow valuation, as it captures the value of all future cash flows that the business will generate after the forecast period, often representing a significant portion of the total valuation.
When should I apply the perpetuity growth method rather than the exit multiple method?
Use perpetuity growth for mature/stable businesses; use exit multiple when relevant comparable are available in the market.
What can I do to make my terminal value assumption better?
You can use macroeconomic trends, industry averages, and historical company performance for more accuracy and better assumption.
What are the risks in estimating terminal value?
The examples of common risks are overestimating growth, underestimating discount rates, or incorrectly applying exit multiples.
Can terminal value be negative?
Not common, but possible, in businesses in distress, when cash flows are forecast to be declining or unviable over the long run.
