What is Terminal Value in a DCF?

Investment Banking technical interviewers are notorious for asking questions on DCF. Within that, interviewers typically want to check the candidates ability to explain Terminal Value.

What is terminal value (TV) in a DCF?

Terminal value attempts to capture the value of a firm beyond the modeling period all the way to eternity. There are typically two methods to capture this. First is the multiple method and the second and more commonly used one is the Gordon growth method.

Gordon growth model formula to calculate

Terminal value = (FCFE5 *(1+g))/ (Cost of Equity – g)

where ..

FCFE5 stands for the free cash flow in the fifth forecasted year

G equals the long term sustainable growth of the company's free cash flows from the end of the 5th year to eternity.

Cost of Equity will need to be deduced using the CAPM formula.

Typically, Terminal Value resulting in more than 70% of the company's total fair value may indicate that the analyst is being too aggressive on the assumptions for long term sustainable growth.

This is especially true for more mature companies. On the other hand, companies such as Facebook and Amazon who have low diffusion rates and a longer runway for growth can get away with a much higher terminal value proportion of the companies total fair value derived from the DCF.