The two methods for calculating terminal value
The two standard approaches are the Gordon Growth Model (perpetuity method) and the exit multiple method. Gordon Growth Model: TV = FCFₙ₊¹ / (WACC − g), where FCFₙ₊¹ is the free cash flow in the first year beyond the forecast period and g is the assumed long-run perpetuity growth rate. Typically g is set at 2–3% (approximately long-run nominal GDP growth) — any higher implies the company will eventually overtake the entire economy. With WACC of 10% and g of 3%, the terminal value multiple on FCF is 1/(10%−3%) = 14.3×. Exit multiple method: apply an EV/EBITDA multiple at the end of the forecast period (e.g., 10× EBITDA) and discount that EV back to today. This is more commonly used in practice because it anchors on observable market multiples rather than an abstract perpetuity assumption.
Why terminal value is both essential and problematic
The dominance of terminal value in DCF creates a fundamental problem: you are constructing a rigorous 10-year model, yet the answer is driven by a single assumption about what happens in perpetuity beyond that model. The perpetuity growth rate is unknowable — no one genuinely knows what a company’s growth rate will be in 2035–2045 and beyond. A single basis point change in the discount rate or growth assumption moves the terminal value materially. This is why DCF valuation is best understood not as a precise price but as a sensitivity analysis tool: what must you believe about growth and returns for this price to make sense? High-multiple tech companies imply extremely optimistic terminal growth assumptions — the discipline of the DCF is making those assumptions explicit rather than embedding them silently in a high P/E multiple.
What this means for you
When you see a DCF in an investment bank pitch deck or equity research report, always look at the terminal value assumptions: what growth rate and exit multiple are assumed, and what percentage of the total value does the TV represent? If TV is 85% of value and the perpetuity growth rate is 5% — a number well above GDP growth — the valuation is heavily dependent on an optimistic assumption about long-run performance. The most rigorous DCF practitioners run sensitivity tables across WACC and growth rate combinations, showing the range of possible values rather than a single point estimate. A valuation that shows "$X is worth $50–$90 depending on assumptions" is more honest and more useful than one claiming precisely "$67.35."