Terminal value: most of the DCF in one number
“How do you calculate terminal value, and which method is better?”
Terminal value is usually most of a DCF's value, so interviewers probe whether you can calculate it, discount it and defend it.
Terminal value prices everything after the forecast, either as a growing perpetuity or as a sale at a market multiple. Then it still has to be discounted to today.
Method 1: perpetuity (Gordon) growth
Assume free cash flow grows at a steady, modest rate forever. Terminal value = next year's FCF ÷ (WACC − growth). The growth rate should stay below long-run economic growth, roughly 2–3%; nothing can outgrow the economy forever.
- 1Next year's FCF = 150 × 1.025 = $153.75.
- 2Terminal value = 153.75 ÷ (9% − 2.5%) = 153.75 ÷ 0.065 ≈ $2,365.
- 3Discount 5 years: 2,365 ÷ 1.09⁵ ≈ 2,365 ÷ 1.539 ≈ $1,537 today.
Method 2: exit multiple
Assume the company is sold at the end of the forecast at a multiple of EBITDA, based on today's comparable companies. It's market-based and easy to explain, which is why bankers use it often.
Sanity-check each with the other
If you used an exit multiple, back out the implied perpetuity growth rate. If it's 7%, your multiple is too rich. If you used perpetuity growth, back out the implied exit multiple and compare it with peers.
Dashed: cash flow that year. Filled: what it's worth today. The further out, the more it shrinks.
Try dragging terminal growth and watch EV.
The formula uses next year's cash flow (final year × (1 + g)), and the result is as of the end of the forecast. Missing either step is the classic terminal value mistake.
Say it like this
There are two common ways. The perpetuity growth method takes the final year's free cash flow, grows it one more year, and divides by WACC minus a long-term growth rate. The exit multiple method applies a multiple, usually EV/EBITDA from comparable companies, to the final year's EBITDA. Neither is strictly better: bankers often use the exit multiple and cross-check it against the implied growth rate. Either way, the terminal value is as of the end of the projection period, so it has to be discounted back to today.
Traps to avoid
- ✕Leaving the terminal value undiscounted.
- ✕Using a terminal growth rate above long-run GDP growth.
- ✕Using this year's cash flow instead of next year's in the Gordon formula.
What they'll ask next
›Why is terminal value such a large share of EV?
It covers all years after the forecast, which is most of a durable company's life; the five explicit years are a small slice.
›What's the intuition behind the Gordon formula?
It's the value of a cash stream growing forever: the faster it grows relative to the discount rate, the more it's worth, which is why the WACC − g gap is so sensitive.
›What if WACC is below the growth rate?
The formula breaks (it implies infinite or negative value). It signals the assumptions are unrealistic: growth can't exceed the discount rate forever.
Check yourself
Final-year FCF is $100, terminal growth is 2%, WACC is 10%. Terminal value using FCF × (1 + g) ÷ (WACC − g)?
Put it all together
Build a full five-year DCF and decide if the stock is cheap.