“As a financial analyst, you're asked in an interview: "Walk me through how you'd calculate a DCF's Terminal Value using the Gordon Growth method, and explain why the growth rate assumption matters so much." Walk through how you'd answer that question, using a sample company's final-year free cash flow to show how the terminal value is built and why it ends up dominating total enterprise value.”
As a financial analyst, you're asked in an interview: "Walk me through how you'd calculate a DCF's Terminal Value using the Gordon Growth method, and explain why the growth rate assumption matters so much." Walk through how you'd answer that question, using a sample company's final-year free cash flow to show how the terminal value is built and why it ends up dominating total enterprise value.
Task: explain how the Gordon Growth method converts a company's final projected cash flow into a Terminal Value, and show why that single number can end up carrying most of the total DCF valuation.
You are given the following inputs from a 5-year explicit forecast.
| Line Item | Value |
|---|---|
| Final Explicit-Period Free Cash Flow (Year 5) | $50.0m |
| Perpetuity Growth Rate (g) | 2.5% (0.025) |
| WACC (Discount Rate) | 9.0% (0.09) |
| Number of Discounting Periods (n) | 5 |
| PV of Explicit-Period FCFs (Years 1–5) | $185.0m |
Terminal Value = FCF(final year) × (1 + g) / (WACC − g)
Using this formula, compute the undiscounted Terminal Value as of the end of Year 5.
PV of Terminal Value = Terminal Value / (1 + WACC)^n
Using this formula, discount the Year 5 Terminal Value back to today.
Enterprise Value = PV of Explicit-Period FCFs + PV of Terminal Value
Using this formula, compute Enterprise Value and the share of it that comes from the Terminal Value.
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