How can you determine the appropriate terminal value in discounted cash flow valuation?

2 Two common methods

There are two common methods to calculate the terminal value in DCF valuation: the perpetual growth method and the exit multiple method. The perpetual growth method assumes that the business or the asset will grow at a constant rate forever, and applies a formula that uses the last year's cash flow, the growth rate, and the discount rate. The exit multiple method assumes that the business or the asset will be sold at the end of the forecast period, and applies a multiple (such as EV/EBITDA or P/E) to the last year's earnings or revenue.

3 How to choose a method

The choice of the terminal value method depends on the characteristics of the business or the asset, the availability and quality of data, and the purpose and audience of your DCF valuation. The perpetual growth method is more suitable for mature and stable businesses or assets that have predictable cash flows and growth rates, and that operate in stable and competitive markets. The exit multiple method is more suitable for young and fast-growing businesses or assets that have uncertain cash flows and growth rates, and that operate in dynamic and evolving markets.

4 How to estimate inputs

The inputs for the terminal value calculation should be consistent with the inputs for the forecast period, and should reflect realistic and reasonable assumptions. For the perpetual growth method, you need to estimate the last year's cash flow, the growth rate, and the discount rate. The last year's cash flow should be the free cash flow to the firm (FCFF) or to equity (FCFE), depending on your DCF approach. The growth rate should be lower than or equal to the long-term growth rate of the economy or the industry, and should not exceed the discount rate. The discount rate should be the weighted average cost of capital (WACC) or the cost of equity, depending on your DCF approach. For the exit multiple method, you need to estimate the last year's earnings or revenue, and the exit multiple. The last year's earnings or revenue should be consistent with the measure used for the multiple, such as EBITDA, EBIT, or net income. The exit multiple should be based on the comparable companies or transactions in the same industry or sector, and should reflect the growth and risk profile of the business or the asset.

5 How to check and adjust

The terminal value calculation is subject to uncertainty and sensitivity, so you should always check and adjust your results to ensure that they are reasonable and robust. You can check your results by comparing them with other valuation methods or benchmarks, such as market multiples, asset-based valuation, or relative valuation. You can also perform sensitivity analysis to see how your results change with different inputs or assumptions, such as growth rate, discount rate, or exit multiple. You can adjust your results by using different terminal value methods or inputs, or by applying a margin of safety or a discount factor to account for the uncertainty and risk of the terminal value.