How do you value everything after your forecast ends?

Your explicit forecast stops at year five — but the business doesn't. Everything from year six to forever gets captured in one number: the terminal value. And here's the uncomfortable truth: in most DCFs, this single number is the largest part of the answer. Handle it with care.

Two ways to close the model

The perpetuity method. Assume that after your forecast, free cash flow grows forever at a modest, steady rate. A perpetuity formula turns that endless, gently growing stream into one present value. The key discipline: the perpetual growth rate must be small, and it must be quoted in the same units as your discount rate. That last clause does more work than it looks. The WACC built two lessons ago — a 10% required return on equity, 4% after tax on debt — is a nominal rate: it already contains expected inflation. So the growth rate has to be nominal too, and the ceiling is long-run nominal economic growth, which is real growth of perhaps 2–3% plus inflation of perhaps 2%. Against that ceiling 5% is not impossible; it is roughly the ceiling itself, which is a different criticism and a much weaker one. Compare a nominal growth rate against a real ceiling and you will call ordinary assumptions absurd. Mix the two the other way — a real growth rate under a nominal discount rate — and you will undervalue every company you touch, by roughly the inflation rate, forever.

The exit-multiple method. Assume that at the end of your forecast, the business could be sold for some multiple of its cash flow or earnings — the kind of multiple similar companies trade at today. It borrows a market judgment for the endpoint instead of a growth assumption.

A rounded example

Take year-5 free cash flow of €514, growing 2.5% forever, discounted at an 8% WACC. The perpetuity is roughly €514 × 1.025 ÷ (0.08 − 0.025) ≈ €9,580 as of year 5 — which you then discount back to today. Notice the size: that terminal value dwarfs the five forecast years combined. Most of your valuation lives in the part you understand least.

Where terminal value goes wrong

• Growth too high. A terminal rate at or above nominal GDP growth, the 4 to 5% ceiling drawn above, assumes the company eventually becomes the economy. Keep it below long-run nominal GDP growth, and treat every tenth of a point above the inflation rate as a claim to be defended.
• The tiny-gap explosion. In the perpetuity, you divide by (discount rate − growth). As growth creeps toward the discount rate, that gap shrinks and the value explodes toward infinity. A small change in either number can double the answer — a fragility we'll dissect in the final unit.
• Cross-check the methods. Compute terminal value both ways. If perpetuity and exit-multiple disagree wildly, one of your assumptions is unreasonable — a free sanity check.

Try it now

1. Take your year-5 free cash flow and apply a perpetuity growth of 2.5% against an 8% discount rate. Note how large the terminal value is versus the sum of the five forecast years — most of your valuation is about to live in the part you understand least.
2. Now close the model the other way, with a market judgement instead of a growth assumption. Real exit multiples, published:

Apply the EV/EBITDA multiple to your year-5 figure as an exit-multiple terminal value. Do the two methods roughly agree? A wild disagreement means one of your assumptions is unreasonable — and finding out which is a free sanity check. 3. Use a comparable rather than whatever company happens to be in front of you. The screener, filtered to one industry and to US listings, gives the peer set:

Keep to one market: across all exchanges the largest "peers" are the same company's Canadian and German listings. Even within the US, one company can appear twice, as an over-the-counter line and as an ADR. One line per company, with its published multiple:

Take the median of the five as your exit multiple, which is a far more defensible endpoint than one name's. If one figure sits far from the rest, suspect the currency before the business: four of these five file their statements in won, yen or yuan. 4. Change the perpetuity growth from 2.5% to 3.5% and recompute. Watch how much the terminal value jumps from a single point — you are dividing by (discount rate − growth), and that gap shrinking is what makes the answer explode. Your first glimpse of the sensitivity coming in Unit 4.