How to Discount Terminal Value in a DCF Model

Terminal value represents a business’s estimated worth beyond the explicit forecast period in a discounted cash flow (DCF) model. It is a significant component of financial valuation, capturing value generated once a company’s growth has stabilized and operations reach a steady state. Since projecting cash flows indefinitely is impractical, terminal value quantifies this long-term value. This calculation accounts for a company’s going-concern value, extending beyond the typical five to ten-year detailed forecast horizon.

Calculating Terminal Value

Terminal value calculation estimates a company’s worth beyond the detailed forecast period. Two primary methods are employed: the Perpetual Growth Model and the Exit Multiple Model. These approaches provide a raw terminal value that is then discounted to its present-day equivalent.

The Perpetual Growth Model, also known as the Gordon Growth Model, assumes a company’s free cash flows will grow at a constant rate indefinitely after the explicit forecast period. This method is useful for established companies with predictable cash flows and stable, long-term growth prospects. The formula is: Terminal Value = FCFn+1 / (WACC – g).

FCFn+1 represents the free cash flow for the first year beyond the explicit forecast period, often calculated by growing the final year’s free cash flow (FCFn) by the perpetual growth rate (g). The Weighted Average Cost of Capital (WACC) is the discount rate, reflecting the overall cost of financing the company’s assets. The perpetual growth rate (g) is the assumed constant rate at which cash flows will grow into perpetuity.

The perpetual growth rate significantly impacts terminal value. This rate should be realistic and sustainable, typically falling below the expected long-term inflation rate or nominal Gross Domestic Product (GDP) growth. Common rates range from 1% to 3%, reflecting a conservative outlook. The perpetual growth rate (g) must be less than the discount rate (WACC) for the formula to yield a sensible result.

The Exit Multiple Model estimates terminal value by applying a market-derived multiple to a projected financial statistic in the final year of the explicit forecast period. This method reflects the market’s current valuation of comparable companies, assuming the company being valued will exit at a similar multiple. Common financial metrics include Earnings Before Interest, Taxes, Depreciation, and Amortization (EBITDA) or Earnings Before Interest and Taxes (EBIT).

To implement this model, an appropriate multiple, such as Enterprise Value/EBITDA, is selected from comparable publicly traded companies or recent acquisition transactions. This multiple is then multiplied by the subject company’s projected EBITDA or EBIT in the terminal year. For instance, if the terminal year’s projected EBITDA is $100 million and the chosen exit multiple is 7.0x, the raw terminal value is $700 million.

The Exit Multiple Model offers a market-based perspective, incorporating investor sentiment and valuation trends. It is favored by industry professionals due to its direct linkage to observable market data. While the Perpetual Growth Model relies on theoretical long-term growth assumptions, the Exit Multiple Model provides a snapshot valuation based on current market conditions. Both methods capture the business’s value beyond the detailed forecast, providing a substantial portion of the total DCF valuation.

Determining the Discount Rate

Determining the appropriate discount rate translates future cash flows into their present-day equivalent. For valuing a company’s operations, the Weighted Average Cost of Capital (WACC) is the most suitable discount rate. WACC represents the average rate of return a company expects to pay to all its capital providers, weighted by their respective proportions in the capital structure.

The WACC formula encompasses two primary components: the cost of equity and the cost of debt, adjusted for the tax deductibility of interest. The formula is: WACC = (E/V Re) + (D/V Rd (1 – T)). ‘E’ denotes the market value of equity, ‘D’ represents the market value of debt, and ‘V’ is the total market value of the company’s capital (E + D).

The cost of equity (Re) reflects the return required by equity investors for the risk of investing in the company’s stock. The Capital Asset Pricing Model (CAPM) is a common method for calculating the cost of equity: Re = Rf + Beta (Rm – Rf).

Rf is the risk-free rate, representing the return on an investment with no risk, such as a long-term U.S. Treasury bond. The yield on a 10-year U.S. Treasury Note is frequently used as a proxy, recently around 4.2% to 4.3%. Beta (β) measures a company’s stock price volatility relative to the overall market, indicating systematic risk. A beta of 1.0 suggests the stock moves with the market; a beta greater than 1.0 implies higher volatility.

The term (Rm – Rf) is the equity risk premium (ERP), the additional return investors expect for investing in the stock market compared to a risk-free asset. The ERP compensates investors for inherent risks like market volatility and potential capital loss. Historically, the U.S. equity risk premium has ranged from 4% to 6%.

The cost of debt (Rd) is the interest rate a company pays on its borrowings. This can be estimated from the yield to maturity on outstanding bonds or by assessing interest rates on comparable debt instruments for companies with similar credit profiles. For private companies without publicly traded debt, credit ratings from agencies like S&P, Moody’s, or Fitch can help determine an implied cost of debt by adding a yield spread over the risk-free rate.

The cost of debt provides a tax shield. Interest expenses are tax-deductible for corporations, reducing taxable income and liability. The after-tax cost of debt is calculated by multiplying the pre-tax cost of debt by (1 – T), where ‘T’ is the corporate tax rate. The U.S. federal corporate income tax rate is a flat 21%. This tax deductibility makes debt a relatively cheaper financing source compared to equity, which lacks a similar tax benefit.

Applying the Discount

Applying the discount rate to the calculated terminal value translates a future lump sum into its present-day worth. This process, known as present value (PV) calculation, accounts for the time value of money: a dollar today is worth more than a dollar in the future due to its earning potential.

The fundamental formula for calculating present value is: PV = FV / (1 + r)^n. ‘PV’ represents the present value of the terminal value, or what future terminal value is worth today. ‘FV’ is the future value, specifically the raw terminal value calculated using either the Perpetual Growth Model or the Exit Multiple Model.

The variable ‘r’ is the discount rate, the Weighted Average Cost of Capital (WACC) derived previously. This rate reflects the risk associated with the future cash flows encapsulated in the terminal value. A higher discount rate results in a lower present value, reflecting greater risk or a higher required return. Conversely, a lower discount rate yields a higher present value.

The exponent ‘n’ represents the number of periods, typically years, between the terminal year and the present valuation date. For instance, if the explicit forecast period is five years, and terminal value is estimated at the end of year five, ‘n’ would be 5 when discounting it back to year zero. This ensures the terminal value is brought back to the same starting point as the explicit forecast period’s discounted cash flows.

To illustrate, if the raw terminal value is $1,000,000 at the end of year five and the WACC is 10%, the present value is calculated as: PV = $1,000,000 / (1 + 0.10)^5. This yields approximately $620,921. This discounted amount signifies the projected future value of the company’s long-term operations in today’s terms.

This present value calculation is a direct application of compound interest in reverse, “uncompounding” the future value back to the present. It isolates the post-forecast period’s contribution to the company’s total intrinsic value.

Incorporating Discounted Terminal Value

The discounted terminal value is integrated into a complete valuation model, a Discounted Cash Flow (DCF) analysis, to determine a company’s total enterprise value. A DCF model consists of two main components: the present value of free cash flows from an explicit forecast period and the present value of the terminal value. These two components are summed to arrive at the total enterprise value.

The explicit forecast period usually spans five to ten years, during which a company’s free cash flows are projected. Each year’s projected free cash flow is discounted back to the present using WACC. This provides the present value of cash flows expected during the near-term, high-growth phase or predictable operations.

Once determined, the present value of the terminal value is added to the sum of the explicit forecast period’s discounted free cash flows. This cumulative sum represents the company’s total enterprise value.

Enterprise value reflects the market value of the entire business, including its equity and debt, assuming it continues as a going concern.

Terminal value often constitutes a substantial portion of the total enterprise value, frequently accounting for 50% to 80% or more in a DCF model. This highlights that a company’s long-term, stable cash flow generation is a primary driver of its overall intrinsic value.

Integrating the discounted terminal value provides a holistic view of a company’s worth, extending valuation beyond a limited projection horizon. It acknowledges that businesses operate indefinitely, generating value into the future. Accurately estimating and discounting this long-term value is fundamental for a complete valuation.