A discounted cash flow forecasts a handful of years in detail and then has to stop. Terminal value is the figure that stands for everything after the last forecast year: not an admission that the business ends there, but the opposite — an estimate of what it is worth as a going concern at that point, collapsed into one number and discounted back with the rest.
There are two conventional ways to produce it. The perpetuity growth method assumes the final year’s cash flow grows at one modest rate for ever. The exit multiple method assumes the business is worth some multiple of its final-year figure, the way a comparable company would be priced. They answer the same question from opposite directions, and a model where the two disagree wildly is telling you something about its own assumptions.
g is the terminal growth rate and k the discount rate. The terminal value is measured as at the final forecast year, so it still has to be discounted back: TV ÷ (1 + k)n. Note what the denominator does as g approaches k — at or above the discount rate the perpetuity has no finite value at all.
Suppose the final forecast year produces $120m of free cash flow, the discount rate is 10% and cash flow is assumed to grow at 2.5% for ever afterwards:
Discounted back five years at 10%, that is about $1,018m of present value — against roughly $420m for the five forecast years themselves. Seven tenths of the answer comes from the one assumption nobody can check. Raise terminal growth from 2.5% to 3.5% and the terminal figure jumps by more than 15%, without a single forecast year changing.
Always look at terminal value as a share of the total. Under half is a model resting mostly on its forecast; over three quarters is a model resting on a perpetuity, and the five years of detailed work in front of it are not really doing the job.
Keep terminal growth genuinely terminal. A rate above long-run economic growth implies the company eventually becomes the whole economy, which is a claim no spreadsheet should make quietly — low single digits is the defensible range, and the further above inflation it goes the more it needs arguing for.
In the app, Advanced DCF offers both constructions: a terminal growth rate and an exit multiple on free cash flow, starting in agreement so that they part only once you move one of them.
It matters most where the forecast period is short relative to the life of the business — which is nearly always. It matters most of all for a company still growing quickly at the end of the forecast, because a high final-year cash flow is being multiplied by a perpetuity factor, and the two compound.
It is a judgement about a year nobody can see, expressed to three significant figures. The perpetuity formula is also mathematically violent near its own boundary: as the growth rate approaches the discount rate the denominator approaches zero and the value approaches infinity, so a model can be tipped from “reasonable” to “absurd” by a change of half a percentage point. The exit-multiple alternative is not safer, merely differently exposed — it imports today’s market pricing into a valuation that was supposed to be independent of it.