Terminal value: where most of a DCF lives

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Key idea: Most of a DCF's answer comes from the years after the forecast ends, so the long-run growth assumption deserves the most suspicion.

Nobody can forecast a company year by year forever, so a DCF usually covers 5 or 10 years in detail and then adds a terminal value: one number standing in for every year after that.

The common formula assumes cash keeps growing at a steady rate g forever: next year's cash divided by (discount rate - g). With $10 of cash next year, a 9% discount rate and 3% growth, the terminal value is $10 / 0.06 = $167.

In a typical DCF, the terminal value is 60-80% of the total. Push g from 3% to 4% and the same example becomes $10 / 0.05 = $200, a 20% jump from a one-point change in a guess about the far future.

Two sanity checks: long-run growth should not exceed the economy's growth for long, and it must stay well below the discount rate, or the formula explodes.

Quick check

Next year's cash is $8, the discount rate is 10% and long-run growth is 2%. What is the terminal value?

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