Terminal Value
Terminal value is the part of a discounted cash flow valuation that stands for everything the business earns after the explicit forecast ends — the value at the end of year five or ten of all the years beyond, estimated either as a growing perpetuity of the final year's cash flow or as an exit multiple of its earnings. It is usually the largest part of the valuation, and the part that rests on the fewest facts.
- Also known as
- TV, Continuing value, Exit value
- Used at
- every discounted cash flow — in fairness opinions, investment cases, impairment tests and the valuation of fintechs whose cash flows are years away
- Binding
- no — a modelling choice; but a fairness opinion or an impairment test that depends on it is challenged on it
- Typical share
- 60–80% of enterprise value in a five-year DCF of a growing company; more for a fintech that is loss-making in the forecast years
- Typical methods
- the Gordon growth formula — final-year free cash flow × (1 + g) ÷ (WACC − g), with g at or below long-run inflation and GDP growth (2–3%) — or an exit multiple applied to final-year EBITDA, cross-checked against each other
- Parties
- the analyst who chooses the method and the assumptions, and everyone who has to believe them
How terminal value works in practice
A discounted cash flow forecasts the company's free cash flows for a period the analyst can defend — five years, sometimes ten — and discounts them to today at the cost of capital. But the company does not stop at year five. The terminal value captures what comes after: assume the final year's cash flow grows at a steady rate forever, and the value of that stream is the cash flow divided by the difference between the discount rate and the growth rate. Discounted back to today, that lump is added to the forecast years' value to give the enterprise value.
The arithmetic is sensitive in a way that rewards care. At a 10% discount rate and 2% growth, the terminal value is 12.75× the final year's cash flow; at 3% growth it is 14.7×; a single point of growth moves the valuation by 15%. So the assumptions are tested against each other: the exit multiple implied by the perpetuity method should look like the multiples real buyers pay, and the growth rate implied by an exit multiple should look like something a mature company could sustain. A terminal value that implies a payments company grows at 6% forever, or trades at 25× EBITDA in year five, is a valuation of a wish.
For a fintech that is loss-making through the forecast, the terminal value is almost the whole valuation, which is why such companies are usually valued on comparables and precedents instead, with the DCF as a check on whether the story could ever justify the price.
Example
A lending platform's five-year forecast reaches €12m of free cash flow in year five. At a 10% cost of capital and 2.5% perpetual growth, the terminal value at year five is €12m × 1.025 ÷ (0.10 − 0.025) = €164m, which discounts to €102m today; the five forecast years' cash flows discount to €28m. Enterprise value €130m, of which 78% is the terminal value. The implied exit multiple is €164m ÷ €15m of year-five EBITDA, 10.9× — in line with the sector's precedents, so the analyst keeps it. A colleague's model at 3.5% growth gives a €191m terminal value and a €146m enterprise value; the €16m difference is one percentage point of growth in perpetuity, and the investment committee asks which of the two anyone would defend.
Common mistakes
- A perpetual growth rate above the economy's, which makes the company the economy in the long run. - An exit multiple borrowed from today's market applied to a year-five business that will be more mature. - Terminal value computed on a final-year cash flow that is not normalised — a year of unusually low capex or working capital release. - Ignoring that 70–80% of the valuation sits in the terminal value and presenting the forecast years as the analysis. - Using a DCF to value a fintech that has no positive cash flow in the forecast, and reporting the answer with confidence.