Terminal Value and Sensitivity
Why most of a DCF valuation usually comes from the years after the forecast, how much the result moves when the discount rate or growth changes, and how to check a terminal value for sense.
The short version
In most DCF valuations, the terminal value, everything after the forecast years, makes up most of the total. For STU Corp it's about three quarters. That makes the result very sensitive to two assumptions: the discount rate and the long-run growth rate. Moving either by one percentage point changes STU Corp's estimated value by roughly 10% to 18%. A sensitivity table shows this at a glance, and checking what multiple of cash flow the terminal value implies keeps it grounded.
By the end of this lesson, you'll be able to
- Explain why the terminal value usually dominates a DCF
- Read a sensitivity table and explain what it shows
- Check a terminal value against the multiple it implies
Why this matters
Discounted Cash Flow, Step by Step estimated STU Corp at about $44.69 a share, and noted that about three quarters of that came from the terminal value. Whenever most of an answer rests on one part of a calculation, it's worth knowing how fragile that part is. This lesson tests it.
Why the terminal value dominates
A five-year forecast covers only five years of a business that may run for decades. The terminal value stands in for all the years after that, so it naturally carries most of the value. The more a company's value depends on the distant future, as with fast-growing young companies, the larger the terminal value's share becomes.
A sensitivity table
A sensitivity table recalculates the value for a range of assumptions, so you can see how much each one matters. Here is STU Corp's value per share, with five years of 10% growth, for different discount rates and long-run growth rates.
| Discount rate | Long-run growth 2% | Long-run growth 3% | Long-run growth 4% |
|---|---|---|---|
| 8.8% | $46.23 | $52.64 | $61.72 |
| 9.8% | $40.09 | $44.69 | $50.87 |
| 10.8% | $35.36 | $38.78 | $43.21 |
Moving the discount rate by one point either way changes the base value by about 13% to 18%. Moving long-run growth by one point changes it by about 10% to 14%. Every cell is a reasonable-sounding set of assumptions, yet the values run from about $35 to about $62. Against a $50 price, the table says STU Corp could look overvalued or undervalued depending on assumptions that no one can know precisely.
Growth in the forecast years matters too
Keeping the 9.8% discount rate and 3% long-run growth:
| Yearly growth, years 1 to 5 | 8% | 10% | 12% | 14% |
|---|---|---|---|---|
| Value per share | $41.15 | $44.69 | $48.48 | $52.53 |
Faster growth in the forecast years raises the value both directly and by raising the starting point for the terminal value.
The rest of this lesson is for members
Still to come in this lesson: Check the terminal value against a multiple, the key takeaways, and 2 quiz questions with explanations.
Membership opens every lesson in the curriculum, the capstone projects, the interactive tools, and the members-only channels in the Hyperion Entities Discord. The first lesson of every module stays free.
Go deeper
- Scenario Analysis: Bull, Base, and Bear CasesValuation and Modeling (depth track)
- Valuation Under UncertaintyValuation and Modeling (depth track)
- Comparable Companies and Precedent TransactionsValuation and Modeling (depth track)