A terminal value worth three-quarters of the answer is usually arithmetic, not a defect, and the share can be predicted before a single cash flow is typed.
On a five-year forecast discounted at 9 per cent with 2 per cent perpetual growth, the terminal value is normally about 72 per cent of enterprise value, and nothing is wrong with the model when it is. For a business already at steady state the share is ((1 + g) ÷ (1 + WACC)) to the power of the forecast years: 71.76 per cent here. Cawdrey Instruments, the case in Business Valuation, comes out at 72.78 per cent.
Worked in full in Business Valuation by Julian R. Sterling, with every figure reproduced in a free workbook.See the book on Amazon →
Reviewers often treat a terminal value above two-thirds of the answer as a warning sign. The share is mostly arithmetic: it is fixed by the forecast length, the discount rate and the growth rate, before anyone has typed a cash flow. What deserves scrutiny is not the share but the two inputs that drive it, and the year-five cash flow it capitalises.
| Year | Revenue growth | EBITDA | Free cash flow | Present value at 9% |
|---|---|---|---|---|
| 1 | 6.0% | 8,904,000 | 4,664,000 | 4,278,899 |
| 2 | 5.5% | 9,393,720 | 4,920,520 | 4,141,503 |
| 3 | 5.0% | 9,863,406 | 5,166,546 | 3,989,521 |
| 4 | 4.5% | 10,307,259 | 5,399,041 | 3,824,816 |
| 5 | 4.0% | 10,719,550 | 5,615,002 | 3,649,366 |
| Sum | 19,884,106 |
Revenue starts at 48,000,000 with a 17.5 per cent EBITDA margin, and 52.38 per cent of EBITDA converts to free cash flow in every year. The cost of capital is 9.0 per cent and perpetual growth 2.0 per cent.
Terminal value at year N = FCFN × (1 + g) ÷ (WACC − g)
Share = PV of terminal value ÷ (PV of forecast flows + PV of terminal value)
Steady-state benchmark = ((1 + g) ÷ (1 + WACC))N
In Excel: =F5*(1+g)/(WACC-g)/(1+WACC)^5 for the present value of the terminal value, and =((1+g)/(1+WACC))^5 for the benchmark.
Step 1. Year-five free cash flow of 5,615,002 is capitalised at 1.02 ÷ 0.07 = 14.57 times, giving a terminal value of 81,818,603.
Step 2. Discount it five years at a factor of 0.6499: 53,176,478 today.
Step 3. Add the 19,884,106 of discounted forecast flows: enterprise value is 73,060,585, of which the terminal value is 53,176,478 ÷ 73,060,585 = 72.78 per cent.
Step 4, the benchmark. If the business already grew at 2 per cent from year one, every flow would be the previous one times 1.02, discounted at 1.09, and the share left after five years would be (1.02 ÷ 1.09)5 = 71.76 per cent. Cawdrey sits one point above it because its forecast growth runs above 2 per cent, which pushes value towards the later years.
Extend the explicit forecast to ten years, with years six to ten growing at the same 2 per cent as the perpetuity. Nothing about the business changes, and the enterprise value is still 73,060,585 to the unit. But the forecast years now carry 34,902,379 and the terminal value 38,158,205, so the share falls to 52.23 per cent. The steady-state benchmark for ten years is 51.49 per cent.
A longer forecast lowers the share without lowering the risk. Years six to ten were simply moved from one line to another. If those years are a mechanical extrapolation at the perpetual growth rate, the lower share is cosmetic.
| WACC \ growth | 1% | 2% | 3% |
|---|---|---|---|
| 8% | 72.97% | 76.08% | 79.40% |
| 9% | 69.85% | 72.78% | 75.91% |
| 10% | 66.90% | 69.66% | 72.60% |
Across a plausible grid the share stays between two-thirds and four-fifths. The values behind those cells are not nearly so stable: at 8 per cent and 3 per cent growth the enterprise value is 99,150,783, at 10 per cent and 1 per cent it is 58,488,333. Moving the cost of capital alone from 8 to 10 per cent takes value from 85,393,469 to 63,814,891, a span of 21,578,578, and 95.1 per cent of that span comes through the terminal value.
That is the useful reading of a high share: not that the model is wrong, but that the cost of capital and the growth rate are where the work of a review belongs. The forecast years, however carefully built, carry about a quarter of the answer.
The common mistake is to judge a DCF by its terminal value share and to "fix" a high one by lengthening the forecast. The fix changes the presentation and leaves the value where it was. The real checks are three. Is the year-five cash flow a normal year, with capex at a sustainable level above depreciation and working capital growing with revenue? Is the growth rate defensible for ever? And what exit multiple does the perpetuity imply? On Cawdrey the terminal value is 7.63 times year-five EBITDA, a figure that can be set beside observed multiples, which a percentage cannot.
Compute ((1 + g) ÷ (1 + WACC))N before you look at the share: if the model sits near it, the share is arithmetic, not a defect. Then spend the review on the year-five flow, the cost of capital and the growth rate. The full Cawdrey build, with the terminal value on its own sheet and its share on the page, is in the free workbook for this case; the DCF terminal value template runs the same test on your own forecast, and the growth rate a multiple implies turns the terminal value around to read the growth hidden in a price.
Not by itself. With a five-year forecast the share for a steady-state business is ((1+g)/(1+WACC))^5, which is 71.76 per cent at 9 per cent and 2 per cent. At 8 per cent and 3 per cent the Cawdrey model gives 79.40 per cent. Review the growth rate and the year-five cash flow, not the percentage.
Only if the extra years contain real information. Extending Cawdrey's forecast to ten years at the perpetual 2 per cent growth rate cuts the terminal value share from 72.78 to 52.23 per cent and leaves enterprise value at exactly 73,060,585. The risk has moved lines, not shrunk.
Divide the terminal value by year-five EBITDA to get the exit multiple it implies, and compare that with observed trading and transaction multiples. Cawdrey's terminal value of 81,818,603 is 7.63 times year-five EBITDA. Also check that year-five capex and working capital reflect a sustainable normal year.
The discounted cash flow behind these figures is built across chapters 4 to 8 of Business Valuation. The book takes the same case from first principles to the decision, chapter by chapter, and every figure it prints is a live formula in the free companion workbooks.
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