Terminal Value & The Model#

We have forecasted cash flows for 5-10 years. But companies (hopefully) last longer than that. How do we value the cash flows from Year 11 to... forever?

This is called the Terminal Value. In many DCF models, the Terminal Value accounts for 60-80% of the total value!

The Lemonade Stand Empire (Why Growth Must Stop)#

Imagine a Lemonade Stand growing at 20% every year.

Year 1: $100
Year 10: $619
Year 50: $910,000
Year 100: $8 Billion

If you assume a company grows faster than the economy (2-3%) forever, it will eventually become larger than the entire GDP of the world. This is the most common mistake in valuation.

Two Ways to Calculate Terminal Value#

1. Perpetuity Growth Method (Academic Favorite)#

Assume the company grows at a constant rate ($g$) forever.

Perpetuity Growth Method

TV = \frac{FCF_n \times (1 + g)}{WACC - g}

Where

TV=Terminal Value

FCF_n=Final Year Free Cash Flow

g=Perpetual Growth Rate (2-3% max)

WACC=Weighted Average Cost of Capital

g (Terminal Growth Rate): Crucial assumption. It cannot be higher than the growth rate of the global economy (usually 2-3%).

2. Exit Multiple Method (Industry Favorite)#

Assume the company is sold in the final year at a specific multiple (e.g., 10x EBITDA).

Exit Multiple Method

TV = EBITDA_n \times \text{Exit Multiple}

Calculating Intrinsic Value#

Once you have the Terminal Value, the math is straightforward:

Discount the forecasted FCFs (Years 1-10) to Present Value.
Discount the Terminal Value to Present Value.
Sum them up. This is the Enterprise Value.

But wait! We buy stocks (Equity), not the whole Enterprise. We need to get from Enterprise Value to Equity Value.

Enterprise Value -> Equity Value#

Enterprise to Equity Value Bridge

\text{Equity Value} = \text{Enterprise Value} - \text{Net Debt}

Subtract Debt: You have to pay off the lenders first.
Add Cash: You get to keep the cash in the bank.

Share Price

\text{Share Price} = \frac{\text{Equity Value}}{\text{Shares Outstanding}}

The Danger Zone: Sensitivity#

Because Terminal Value is so huge, small changes in assumptions can drastically change the price.

Changing the Terminal Growth Rate from 2.0% to 2.5% might increase the stock value by 20%.
Changing WACC by 1% can swing value by 30%.

Always perform a Sensitivity Analysis. Don't just say "The stock is worth $100." Say "The stock is worth between $85 and $115 depending on growth rates."

Key Takeaways

Terminal Value accounts for the majority of a DCF valuation - Terminal growth rate cannot exceed the economy's growth rate (2-3%), or the company becomes the world - Enterprise Value must be adjusted for Debt and Cash to find Equity Value (Share Price) - DCF is highly sensitive; always use a range of values

Terminal Value & The DCF Model

Learning Objectives