How to Estimate Terminal Value

Cash flows cannot be reasonably forecasted indefinitely when valuing a company using the discounted cash flow (DCF). This is why the DCF is split into (1) an explicit forecast period and (2) a terminal value to represent all cash flows beyond the initial period.

Terminal value generally accounts for 50-75% of a company's total value in the DCF. Yet it's challenging to accurately estimate given its distant projection and sensitivity to assumptions, which can significantly impact intrinsic value.

Terminal Value Methods

Three methods exist to estimate the terminal value figure:

1. Liquidation Value: Estimates value based on selling the company's assets. Calculate this by either adjusting the company's book value of assets for inflation or by estimating the proceeds from selling these assets.
2. Exit Multiple Method (EMM): Most common approach among investment bankers and institutional investors. Here, you apply market multiples from comparable companies (e.g., EV/EBITDA) to your final year forecasted metrics (e.g., EBITDA) in the DCF model.
3. Perpetual Growth Method (PGM): Assumes company will grow its cash flows at a constant rate forever, which cannot exceed the GDP growth rate. Most theoretically sound method for estimating terminal value for ongoing businesses.

Reference the flowchart below to select the appropriate terminal value method:

Determine whether the business will continue to operate indefinitely. If not, use the liquidation value method to estimate the terminal value.

If the business will continue operating after your explicit forecast period (usually 5 or 10 years), decide whether to base terminal value on fundamental growth factors (PGM) or market multiples from comparable companies (EMM).

Note: For companies expected to cease operations with most value in intangible assets rather than physical ones, the liquidation value approach may not be appropriate. Instead, use the PGM with negative growth rates or the EMM with comparable companies experiencing similar decline.

Method #1: Liquidation Value

Liquidation value estimates terminal value based on estimated proceeds from selling the company’s assets at the end of the explicit forecast period. This method values assets individually rather than as part of an operating business.

Liquidation Value Formulas

Liquidation value can be calculated by either (1) adjusting the estimated book value of assets, or (2) estimating future cash flows from asset sales.

Note: If using terminal liquidation value in an equity valuation (FCFE, FCF, or EPS), subtract estimated terminal year debt obligations. If using in a firm valuation (FCFF), use total liquidation value as given.

Approach #1: Book Value of Assets

The first approach adjusts the terminal year book value of assets (accounting value on balance sheet, calculated as original purchase price minus accumulated depreciation) for inflation over their average life:

LV = BV_Term × (1 + i)^t

where:

• LV = liquidation value
• BV_Term = book value of assets (terminal year)
• i = expected inflation rate
• t = average life of assets

This formula accounts for how inflation erodes purchasing power over time, estimating what you'd need to pay in future dollars to replace these assets.

This approach works best with standardized assets that have established market values (e.g., commercial real estate or commodity production equipment), particularly when inflation significantly impacts future value.

Approach #2: Earning Power of Assets

The second approach estimates value based on expected cash flows generated from selling assets, thereby capturing economic reality more accurately than book value:

LV = CF_Term × [(1 - (1 / (1 + r)ⁿ)) / r ]

where:

• LV = liquidation value
• CF_Term = cash flows (terminal year)
• r = discount rate reflecting sale risk
• n = expected years of cash flows

This formula calculates the present value of expected cash flows (actual cash proceeds from selling assets, not accounting measures like net income or existing cash balances) over their remaining productive life.

The expected after-tax cash flows from asset sales are discounted using the cost of capital. While the weighted average cost of capital (WACC) commonly serves as the discount rate, it may be adjusted higher for illiquid or specialized assets, or lower for standardized assets.

Liquidation Value Examples

To understand how to apply these formulas, consider two realistic scenarios:

Example #1: Book Value of Assets

Copper mining company example:

• Current PP&E: $30 billion
• Forecast period number of years: 5 years
• Forecast period CAGR growth: 7%
• Terminal value PP&E estimate: $42.1 billion
• Average asset life: 5 years
• Inflation: 2.5%

LV = $42.1B × (1 + 0.025)⁵ --> $47.6B

The $47.6 billion terminal value reflects the inflation-adjusted replacement cost of the company's assets at the end of the forecast period.

Example #2: Earning Power of Assets

Real estate company example:

• Current annual cash flows: $1.2 billion
• Forecast period number of years: 5 years
• Forecast period CAGR growth: 8.45%
• Terminal year cash flows: $1.8 billion
• Sale period: 12 years (orderly asset disposal)
• WACC (discount rate): 8%

LV = $1.8B × [(1 - (1 / (1.08)¹²)) / 0.08] --> $13.6B

The $13.6 billion terminal value represents the present value of cash flows expected from selling the company's assets over a 12-year disposal period.

Method #2: Exit Multiple Method

Exit multiple method (EMM) estimates terminal value based on applying market-based multiples to a company’s terminal year cash flow. This method values the firm based on how comparable companies trade.

Exit Multiple Method Formula

The EMM formula estimates terminal value by applying market-based multiples to the terminal year metric:

TV = Metric_Term × Exit Multiple

where:

• TV = terminal value
• Metric_Term = terminal year financial metric
• Exit Multiple = market-based valuation multiple from comparable companies

The metric you choose depends on your cash flow forecasting approach and should match the exit multiple type. For instance, if using EV/EBITDA as your exit multiple, you apply it to terminal year EBITDA, not free cash flow to the firm (FCFF).

Exit multiples can be based on two different time periods:

• Last 12 months (LTM) data: Reflects current market conditions and recent company performance rather than potentially outdated historical data.
• Next 12 month (NTM) estimates: Based on consensus analyst forecasts and incorporates expected future performance. May align better with the forward-looking nature of DCF models.

Common Exit Multiples

Each multiple serves a specific purpose, with the choice depending on both company characteristics and availability of comparable data.

Enterprise Value Multiples (FCFF)

• EV/EBITDA: Compares a company's total value (equity and debt) to its core operating earnings before any accounting adjustments. Serves as the standard multiple because it's capital structure neutral and removes depreciation and amortization (D&A) differences.
• EV/EBIT: Compares total firm value to operating earnings after accounting for asset costs through D&A. Works better for companies with significant differences in D&A or varying capital intensity.
• EV/Sales: Compares total firm value to revenue, ignoring profitability entirely. Useful when profitability varies widely or when valuing companies with negative earnings.
• EV/FCFF: Compares total firm value to actual cash generated by operations after all business needs are met. Useful for capturing true cash generation ability when comparable firms also have positive FCFF.

Equity Multiples (FCFE, FCF, or EPS)

• P/E: Compares stock price to earnings per share (EPS). Most common way to compare stock values and the standard equity multiple for profitable companies with stable earnings.
• P/B: Compares stock price to the accounting value of equity. Works when assets are the main source of value, particularly for financial institutions and asset-heavy companies.
• P/S: Compares stock price to revenues. Useful when earnings don't reflect true business value or when earnings metrics aren't meaningful/reliable.
• P/FCFE: Compares stock price to actual cash available to equity shareholders. Best for capturing true shareholder returns, especially when companies have significant debt repayments, require ongoing investment, or have working capital needs that make earnings less meaningful.

Exit Multiple Method Example

For this example, we'll use the EV/EBITDA multiple applied to the terminal year EBITDA from the FCFF forecast model. Assume the company's terminal year EBITDA is $100 million.

The next step involves gathering exit multiples from comparable companies. Here's an example output for a list of comps and their respective EV/EBITDA multiples over the LTM and NTM:

To calculate terminal value, multiply either the average or median multiple by the terminal year EBITDA.

Since terminal value represents a distant future state, NTM multiples often provide a more appropriate benchmark.

The median reduces the impact of outliers and provides a better representation when comps vary significantly. The average works when comparables are closely aligned. In practice, the median is often preferred, especially with smaller samples, because even one company with unusual circumstances can distort the average.

For our example, we'll use the median NTM multiple of 15x:

Terminal Value = $100M × 15x --> $1.5B

However, if you believe the sample size is too small for reliable analysis, if multiples appear unreasonable for the target company, and/or if no truly comparable companies exist, you can reference a broader industry dataset.

Academic databases or industry reports might show an industry average EV/EBITDA multiple of 13x based on 50 or more companies, providing a larger sample size and more conservative estimate. In this case, terminal value is calculated as:

Terminal Value = $100M × 13x --> $1.3B

This broader dataset approach trades precision for reliability when individual comparables are inadequate.

Method #3: Perpetual Growth Method

Perpetual growth method (PGM) estimates terminal value based on assuming stable, infinite growth of cash flows after the explicit forecast period. This is the most theoretically sound method for an ongoing firm.

Perpetual Growth Method Formulas

Terminal value can be estimated using either (1) no-growth perpetuity assuming constant cash flows, or (2) perpetual growth assuming stable growth at or below GDP growth.

Approach #1: No-Growth Perpetuity Method

The first approach assumes the company generates constant cash flows forever with no growth:

TV = CF_n / r

where:

• TV = terminal value
• CF_n = cash flow in final forecast year
• r = discount rate

This approach works for companies operating in highly competitive industries where excess returns trend to zero and growth opportunities are limited. Unlike liquidation value, the company continues operating indefinitely.

Approach #2: Perpetuity Growth Method (Gordon Growth Method)

The second approach assumes cash flows grow at a stable rate indefinitely:

TV = CF_n × (1 + g) / (r - g)

where:

• TV = terminal value
• CF_n = cash flow in final forecast year
• g = perpetual growth rate
• r = discount rate

This approach works for companies with predictable cash flows expected to grow steadily at or below GDP growth indefinitely.

Note: When g = 0, the perpetual growth formula simplifies to the no-growth perpetuity method.

Perpetual Growth Method Constraints

The perpetual growth method (PGM) requires several important constraints to ensure realistic DCF valuations:

Stable Company Characteristics

Terminal year cash flows should reflect characteristics of a stable company.

This means forecasting sustainable growth rates, margins normalized to industry averages, capital expenditures at steady-state levels, reinvestment rates that support the assumed growth, and returns converging toward industry averages.

Growth Rate Constraint

The perpetual growth rate (g) cannot exceed the nominal growth rate of the economy in which the company operates. Otherwise, you're assuming the company becomes larger than the economy itself.

The 10-year risk-free rate (r_f) typically serves as a proxy because the risk-free rate and GDP growth rate share the same inflation expectations embedded in their nominal values. Additionally, real risk-free rates converge to real economic growth rates over the long term.

For multinational firms, the growth rate can be ~1-3% higher since the limiting factor becomes global GDP growth rather than domestic GDP growth. The adjustment depends on the percentage of revenues generated internationally versus domestically.

Note: Use nominal growth rates when forecasting nominal cash flows (the standard approach). If forecasting real cash flows, use real GDP growth rates and the real risk-free rate as the constraint.

Discount Rate Relationship

The perpetual growth rate (g) must be below the discount rate (r). If not, the denominator in the formula becomes negative, producing a meaningless negative terminal value.

Negative Growth

The perpetual growth rate (g) can be negative, implying the firm shrinks gradually each year.

This may be appropriate for firms being phased out due to technological obsolescence, declining industries, or permanent shifts in consumer preferences.

Perpetual Growth Method Examples

For these examples, we'll calculate terminal value using both perpetual growth approaches:

Approach #1: No-Growth Perpetuity

Assume the company's terminal year FCFF is $100 million and the WACC is 9%:

TV = $100M / 0.09 --> $1.11B

The $1.11 billion terminal value assumes the company generates the same cash flows forever without growth.

Approach #2: Perpetuity Growth Method (Gordon Growth Method)

For this example, assume:

• Terminal year FCFF: $100M
• WACC: 9%
• Perpetual growth rate: 2%

If the risk-free rate is ~4%, a 2% perpetual growth rate would suit a mature company that lacks the pricing power or competitive advantages to match economic growth indefinitely:

TV = $100M × (1 + 0.02) / (0.09 - 0.02) --> $1.46B

The $1.46 billion terminal value reflects steady but modest growth continuing indefinitely, staying well below the risk-free rate.

Cross-Checking Terminal Value Methods

To provide a sanity check, investors can cross-check their EMM results with implied growth rates, and their PGM results with implied multiples, ensuring both assumptions are reasonable.

This validation is optional and should supplement, not override, your fundamental understanding of the business.

Implied Perpetual Growth Rate Formula

Use this formula to check if your exit multiple implies a reasonable perpetual growth rate:

Implied Growth Rate = ((TV_EMM × r) - CF_Term) / (TV_EMM + CF_Term)

where:

• TV_EMM = terminal value (exit multiple method)
• r = discount rate
• CF_Term = terminal year cash flow

If the EMM terminal value implies a perpetual growth rate that's unreasonably high/low, this suggests your exit multiple assumptions may need revision.

Implied Exit Multiple Formula

Use this formula to check if your perpetual growth rate implies a reasonable exit multiple:

Implied Multiple = TV_PGM / Metric_Term

where:

• TV_PGM = terminal value (perpetual growth method)
• Metric_Term = terminal year financial metric

If the PGM terminal value implies an exit multiple that's unreasonably high/low compared to current trading multiples, you should reconsider your perpetual growth rate assumption.

Mid-Year Convention Adjustments

When using mid-year convention, adjust the formulas to account for cash flows occurring halfway through the year, with the "(1 + r)^0.5" adjustment reflecting the half-year timing difference.

Implied Perpetual Growth Rate Formula (Mid-Year)

Implied Growth Rate (Mid-Year) = ((TV_EMM × r) - CF_Term × (1 + r)^0.5) / (TV_EMM + CF_Term × (1 + r)^0.5)

Implied Exit Multiple Formula (Mid-Year)

Implied Multiple (Mid-Year) = (TV_PGM × (1 + r)^0.5) / Metric_Term

Example Cross Checks

Using the examples from our EMM and PGM calculations:

Exit Multiple Method

Implied Growth Rate = (($1.5B × 0.09) - $100M) / ($1.5B + $100M) --> 2.2%

Implied Growth Rate (Mid-Year) = (($1.5B × 0.09) - $100M × (1 + 0.09)^0.5) / ($1.5B + $100M × (1 + 0.09)^0.5) --> 1.9%

The EMM terminal value of $1.5B implies a perpetual growth rate of 2.2% and 1.9% with mid-year convention (lower because terminal cash flow is adjusted upward by half a year's growth).

Both align closely with the 2% rate used in our PGM calculation, suggesting the 15x exit multiple is reasonable.

Perpetual Growth Method

Implied Multiple = $1.46B / $100M --> 14.6x

Implied Multiple (Mid-Year) = ($1.46B × (1 + 0.09)^0.5) / $100M --> 15.2x

The PGM terminal value of $1.46 billion implies an EV/EBITDA multiple of 14.6x and 15.2x with mid-year convention (higher because terminal value is adjusted upward by half a year's discount rate).

Both compare favorably to the 15x multiple applied in the EMM, with mid-year convention showing even closer alignment.

The Bottom Line

Terminal value represents the present value of all cash flows beyond the explicit forecast period, typically accounting for 50-75% of a company's intrinsic value in the discounted cash flow (DCF).

Three methods exist for estimating terminal value: (1) liquidation value for asset-heavy or declining businesses, (2) exit multiple method (EMM) for market-based estimates, and (3) perpetual growth method (PGM) for ongoing businesses.

As a final validation step, cross-checking EMM and PGM results helps identify potential errors and ensures internally consistent assumptions across both methods.