Terminal value

Terminal value is the lump sum a discounted cash flow model uses to represent everything a company is expected to generate beyond its explicit forecast years. A forecast might only run three to seven years, but a healthy company does not stop generating cash the day after, so the model needs some way to account for that.

The most common approach assumes the company settles into a slow, steady growth rate forever after the forecast ends, then applies a formula (sometimes called the Gordon Growth model) that reduces to: Final year free cash flow x (1 + long-term growth rate) / (discount rate - long-term growth rate).

Terminal value is often the single largest, least certain piece of a DCF's total estimate, frequently making up somewhere around two-thirds to three-quarters of the final number. That makes the long-term growth rate and discount rate feeding into it worth extra scrutiny.