Where the value sits
A discounted cash flow model projects a company's free cash flow for an explicit period, commonly five to ten years, and then applies a terminal value to represent everything beyond that horizon. The terminal value is usually calculated by assuming cash flows grow at a constant rate forever, and dividing by the difference between the discount rate and that growth rate.
Because the terminal value captures an infinite period, it typically accounts for sixty to eighty percent of the total calculated value. The detailed year-by-year forecast that receives most of the analyst's attention often contributes the minority. The single assumption that receives the least scrutiny contributes the most.
The sensitivity of the formula
The terminal value formula divides by the difference between the discount rate and the terminal growth rate. When those two numbers are close together, small changes in either produce large changes in the result. A model using a nine percent discount rate and a three percent growth rate divides by six percent. Moving the growth rate to four percent divides by five percent, increasing the terminal value by twenty percent from a one-point change in a long-run assumption.
This is not a flaw in the formula. It is a property of valuing very long-dated cash flows. But it means that a valuation which appears precise to the nearest dollar may in fact be a range spanning a third of its own value, depending on an input that cannot be known.
Building a sensitivity grid
The standard response is a sensitivity table: terminal growth rates across the top, discount rates down the side, and the resulting valuation in each cell. A grid of five by five values shows at a glance how much the conclusion depends on the two inputs.
The useful question to ask of the grid is not which cell is correct, since none can be known to be. It is how many cells support the conclusion being drawn. If a security appears undervalued only in the corner of the grid with the highest growth and lowest discount rate, the conclusion rests on a narrow set of assumptions. If it appears undervalued across most of the grid, the conclusion is more robust to being wrong about the long run.
A check on the growth assumption itself
A terminal growth rate is an assumption about a company growing at a constant rate indefinitely. Over a long enough horizon, no company can grow faster than the economy it operates in without eventually becoming that economy. Long-run nominal economic growth in developed markets has historically been in the low single digits. A terminal growth assumption materially above that implies something the arithmetic cannot support.
Checking the terminal growth rate against that ceiling is a simple discipline that catches a large share of over-optimistic models. It is also a reminder that valuation is a structured way of stating assumptions, not a method for discovering what something is worth.
Key points
What to take from this note
- 01Terminal value typically accounts for the majority of a discounted cash flow valuation.
- 02The formula is highly sensitive when the discount rate and growth rate are close together.
- 03A sensitivity grid shows how many assumption combinations support a conclusion, not which one is right.
- 04A terminal growth rate above long-run economic growth implies something the arithmetic cannot support.
Goat Academy is an online financial education institution founded by economist and former investment banker Felix Prehn.
This article is general market commentary published for educational purposes. It is not financial, investment, or tax advice, is not a recommendation to buy or sell any security, and should not be relied upon as a basis for any investment decision. Trading and investing carry risk, including the loss of capital.