Terminal value
Valuing everything after the forecast ends: perpetuity growth versus exit multiple.
- Calculate terminal value by perpetuity growth, growing the final cash flow one year first
- Calculate it by exit multiple and discount it to today
- Translate each method into the other: implied multiple and implied growth
- Explain why the gap between WACC and growth drives the answer
The intuition
A forecast has to stop somewhere, usually after five or ten years, but the business does not stop. Think of an apple orchard: you can forecast the next five harvests in detail, but the trees will keep producing long after that. Terminal value is one number for every harvest after the forecast.
There are two ways to put a number on it. Assume the harvest grows at a steady rate forever and value that stream. Or ask what someone would pay for the orchard at the end of year five, judging by what similar orchards sell for.
Terminal value is usually most of a DCF's value, often 60–80% of enterprise value. So its two inputs, the growth rate and the multiple, deserve more scrutiny than any single forecast year.
Why it works
Perpetuity growth. A cash flow that grows at g a year forever, discounted at WACC, is worth next year's cash flow ÷ (WACC − g). The formula needs the cash flow one year after the forecast ends, so you grow the final year's cash flow once: FCF × (1 + g). The answer is a value at the end of year N, which you then discount N years to today.
Exit multiple. Multiply the final year's EBITDA by the EV/EBITDA multiple that comparable companies trade at. This is also a value at the end of year N.
- Why WACC − g matters so much. At a 9% WACC and 2% growth you divide by 7%. Move growth to 3% and you divide by 6%, and the terminal value jumps by almost 18%. The closer growth gets to WACC, the more violent the effect.
- Growth must be modest. No company can outgrow the economy forever, or it would eventually become the economy. 2–3% is normal for a mature business.
- Each method hides an assumption about the other. A perpetuity value divided by EBITDA is the multiple it implies. An exit-multiple value can be solved for the growth rate it implies. If either one looks unrealistic, an input is off.
| Final-year free cash flow | $50M |
| Perpetuity: 50 × 1.02 ÷ (9% − 2%) | $728.6M |
| Exit: $90M EBITDA × 8.0x | $720.0M |
| Implied multiple: 728.6 ÷ 90 | 8.1x |
| Implied growth from $720M | 1.9% |
The two methods agree within about 1%: a consistent set of assumptions.
The formulas
Grow the final cash flow one year, then capitalize it at the gap between WACC and growth.
What the business would sell for at the end of the forecast, priced like its peers.
The EV/EBITDA multiple your growth assumption is quietly paying.
The growth rate forever that your exit multiple is quietly assuming.
Either value sits at the end of year N, so it still has to be discounted to today.
Worked example
The most common terminal value question. Watch for the one-year growth step: it is the part people forget.
See it move
Same company. Move growth, WACC and the multiple, and see how far apart the two methods drift.
- Push growth up a quarter point at a time. Each step adds more value than the one before, because WACC − g keeps shrinking.
- Watch the implied multiple while you move growth. That is the multiple your growth assumption is paying, and it moves faster than most people expect.
- Raise the exit multiple and watch the implied growth climb. A rich multiple quietly assumes faster growth forever.
- Look for where the curve crosses the dashed line: at that WACC both methods give the same value. If it never crosses, your growth and multiple assumptions disagree.
Run it backwards
Same numbers, reversed: you chose an exit multiple. What growth rate forever does that terminal value assume?
Set the exit value equal to the perpetuity formula and solve for g: TV × (WACC − g) = FCF × (1 + g). Gather the g terms on one side: TV × WACC − FCF = g × (TV + FCF). So g = (TV × WACC − FCF) ÷ (TV + FCF).
Then judge it. Above roughly 4%, the multiple assumes the business outgrows the economy forever. Close to zero, the multiple is cheap for the cash the business produces.
Traps
Say it in the interview
“How do you calculate terminal value, and which method is better?”
Check yourself
4 fresh questions, with new numbers. Answer each one correctly to finish the chapter. Get one wrong and you will see the full working, then you can try it again with new numbers.
Answers within 1% are marked right. Type the number; $, %, x and M are fine. First tries count toward Learned: the topic is Learned once every chapter is done and 75% of first tries were right.
- Perpetuity: FCF_N × (1 + g) ÷ (WACC − g).
- Exit multiple: EBITDA_N × multiple.
- Both sit at the end of year N, so discount them.
- Cross-check: implied multiple and implied growth.