Terminal value is usually most of the answer, and most of the risk
Aswath Damodaran · Session 9: Terminal Value
The idea
The cash flows beyond the explicit forecast are captured in one number, the terminal value, and in most models it is the majority of the total. Damodaran's lecture covers the two ways to estimate it, a perpetual growth rate or an exit multiple, and the question that decides when either can be used: has the firm reached stable growth? A growth rate capped near the economy's, a reinvestment rate consistent with that growth, and a risk profile that has settled. The practical sanity checks follow: terminal value as a share of the total, and the multiple the perpetuity implies against what comparable companies trade at.
Check what share of the value is terminal and what multiple the terminal assumptions imply; those two checks catch most broken DCFs.
When it works
Any DCF review, any interview follow-up on the terminal growth rate, and any model where the answer seems too sensitive to the last year.
When it may fail
The checks flag an implausible terminal value; they do not supply the right one. A young company with no stable state yet makes any terminal assumption a judgement, which the Primer's institutional DCF treats in stages.
How to use it
After building a DCF, compute terminal value as a share of enterprise value and the implied exit multiple. If the share is above three quarters or the multiple is outside the comps range, the forecast period is doing too little work.
Where it came from
Video Session 9: Terminal Value · Aswath Damodaran (NYU Stern)
What the source says. Damodaran's terminal value lecture sets out the ways to estimate it and the conditions under which a firm can be said to have reached stable growth.
Connected ideas
Worth knowing first
A DCF is machinery for one sentence: value is the present value of expected cash flowsEvery cell in a DCF is a claim about future cash or about its risk; if you cannot say which, the cell should not be there.
Says something similar
A capital-structure-neutral cash flow needs a capital-structure-neutral discount rateMatch the discount rate to the cash flow: a flow to all capital providers is discounted at the blended cost of all of them.
Concepts
Put it to work on L3VLUP
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