DCF II: Terminal Value & Reverse DCF

Learning objectives

By the end you can:

1. Compute a Gordon terminal value from a steady-state FCFF, TV = FCFF_T+1 / (WACC − g), and derive, not recite, its three constraints: g capped by the economy (≈ the currency's risk-free rate), reinvestment forced to g / ROIC_terminal, and terminal ROIC faded toward WACC unless a named moat defends it.
2. Prove algebraically that growth adds nothing when ROIC = WACC, and quantify how much terminal value an analyst manufactures by ignoring terminal reinvestment ("free growth").
3. Cross-check a Gordon terminal value with an exit multiple in both directions: compute the implied exit multiple from your TV, and extract the perpetual growth a quoted exit multiple smuggles in. Then explain why the exit multiple can never be the primary method in an intrinsic valuation.
4. Assemble a complete DCF to a per-share value: explicit-period PVs, terminal value, mid-year convention, the enterprise-to-equity bridge (cash, debt, minorities), diluted shares. Then report the output as a defensible range built from a 2-way sensitivity grid and coherent scenarios, not a point.
5. Run a probabilistic read: build and interpret a two-way sensitivity table, weight internally consistent scenarios, and explain what a Monte-Carlo output distribution does and does not tell you.
6. Execute a full reverse DCF: hold the valuation machine fixed, solve by hand-iteration for the growth (or margin, or duration, or required return) that reproduces the market price, translate it into operational language, and judge it against base rates. That is the expectations-investing discipline.
7. Value a dividend payer with the DDM and the H-model (formula, worked example, error bounds), and explain why banks get dividend-based valuation rather than FCFF (previewing M3.10 and M5.01).
8. Audit any DCF, yours or a sell-side analyst's, against the 15 classic mistakes, naming the one-line fix for each.

Prerequisites & connections

Builds directly on:

• M3.01: the growing perpetuity PV = CF₁/(r − g) is the entire mathematical content of terminal value; everything else here is discipline about what CF₁, r, and g are allowed to be. Fisher (real vs nominal) returns when we cap g.
• M3.03: the two WACCs you built from scratch (≈11.0% INR for the UltraTech-style cement leader, ≈7.8% USD for the Home Depot-scale retailer) are used as-is here. M3.03 promised that "M3.05 forces ±1-point WACC sensitivity on every DCF"; this week keeps that promise.
• M3.04: FCFF construction, the g = reinvestment rate × ROIC identity, and sales-to-capital forecasting. The explicit-period forecasts here use exactly that machinery.
• M2.03/M2.04: ROIC built from raw statements, and FCF conversion; the terminal-value constraints are those ideas pushed to infinity.

Feeds into:

• M3.06: relative valuation. The steady-state-multiple algebra you derive here (what P/E or EV/EBIT a perpetuity can justify) is the intrinsic anchor for every comp you'll ever run.
• M3.09/M3.10: the full modeled DCF, and the special cases (banks, cyclicals, money-losers) where today's machinery must be modified.
• Phase 8: Day 2 of the deep dive ends with a reverse DCF; the 12-question teardown's question 11 ("what is the market implying?") is this week's work compressed to five minutes.
• The weekly teardowns from this week onward add a "what's priced in" line. The master schedule flags week 26 as the point where that becomes mandatory.

4.1 Where a DCF is won or lost

Run the arithmetic on any completed DCF and one fact jumps out. The terminal value, the single number capitalizing everything past your forecast horizon, is typically 60–80% of the enterprise value. In the two builds you'll complete this week, the terminal value is 64% of the Indian company's value and 62% of the American one's; shorten the explicit horizon to five years and it rises toward 80%:

Novices react to this in one of two wrong ways. Some conclude the DCF is a sham: "it's all terminal value, so the whole thing is one made-up number." Others never notice, and spend forty hours polishing quarterly working-capital forecasts while their terminal assumptions, set in ninety seconds, quietly determine three-quarters of the answer.

The expert reaction is different, and it starts from an economic truth rather than a modeling artifact: businesses are long-duration assets. A going concern earns most of its lifetime cash far beyond any horizon you can forecast. The terminal value isn't a fudge bolted onto a model; it is the honest admission that most of the value of owning a business is the distant future. That is also why equities are volatile (long-duration assets reprice hard when discount rates or long-run expectations move; you saw this duration logic in M3.02). The response to "TV dominates" is not despair; it is allocation of effort: spend your care where the value is. That means three things, which are the three acts of the week: