IB Manual – DCF with Terminal Value Calculation

This guide is an excerpt from CFI’s free Investment Banking Training Manual

DCF with Terminal Value Calculation

This guide will break down the steps required to perform a DCF with terminal value calculation.

This guide is an excerpt from CFI’s free Investment Banking Training Manual.



  • Separate cash flows into:
    • Visible cash flow period (5 to 10 years on average)
    • Terminal value period (perpetuity)
  • To forecast the FCFF during the visible cash flow period, one needs to understand the company’s business model and key drivers of cash flow.
  • One can forecast terminal value using the perpetuity formula or use comparable company multiples.
  • In the end, company value = value of the future cash flows generated by the company discounted at the required rate of return demanded by the investors.


DCF with Terminal Value Calculation


DCF summary

The following is a summary of DCF valuation:


DCF Valuation Summary



The following is an example of 2-step DCF analysis. Pay attention to the importance of discounting to calculate implied firm value.


2-step DCF Analysis - Illustration


Breakdown of firm value to equity value

More often, analysts are more interested in equity valuation as opposed to firm valuation. Firm value is the value of the entire firm and all the claims by shareholders on the entire value of the firm. To identify the elements of the firm value in which equity can exercise a claim on, we need to adjust non-equity claims from firm value. Take the following full example from the investment banking manual:

The firm value of £21,508 million is the present value of the FCFF generated by the company. Some 34% of this value comes from the visible cash flow period and is represented by the present value of the visible cash flows of £7,268 million.  The remaining £14,240 million (66%) of the firm value is represented by the present value of the terminal value calculation.


Firm Value to Equity Value


The following adjustments are needed to convert firm value to equity value:

  • Debt should be deducted at market value:
    • If market value is not available, the debts’ market value can be estimated by discounting the cash flows at the current refinancing rate (similar to valuing a bond).
    • Market value information can be found for traded debt in the annual report in some jurisdictions.
  • Minority interest represents an outside ownership interest in a subsidiary that is consolidated with the parent for financial reporting purposes. Therefore, minority interests must be removed in the breakdown to equity value
    • Firm value is measured at the market value of all its components. Minorities are a part of the firm value and are valued at market value; otherwise, they are included at book value.
  • If the subsidiary, where the minority interest arises, is quoted, the market value of the minority can be derived; unquoted minorities will need to be valued on a separate basis (using DCF or comps).
  • Due to the accounting rules for the inclusion of joint ventures and associates in the group accounts, the cash flows of these entities are ignored in FCFF valuation.
  • Equity shareholders can exercise an ownership claim on joint ventures and associates. FCFF valuation does not include cash flows generated by joint ventures and associates, as FCFF drives cash flow from the financial information above the EBIT line.
  • As for minority interests, a market value adjustment (usually an addition) to equity value is preferred to calculate the implied equity value. If the value is a material and significant part of the valuation, market value should be used.


Unfunded pension liability

Firm value needs to be adjusted to account for the pension deficit as these pensions are like “debt type” funding. The unfunded deficit liability is deducted when establishing the warranted equity value of the firm. The post-tax, unfunded pension liability should be deducted as ultimately the payments will save corporate tax at the normal rate. This deficit will eventually be funded in the same ratio of debt to equity as is currently used in the WACC formula and therefore does not need to be adjusted by WACC.


Comparison of FCFE and FCFF DCF valuation

Note that FCFF valuation is the most commonly used method for valuation purposes. Further, once FCFF is understood properly, FCFE is just an additional step. FCFF discounts unlevered (cash a business has before it has met its financial obligations) cash flow at the weighted average cost of capital while FCFE discounts levered (cash a business has after it has met its financial obligations) free cash flow at the cost of equity.

Read CFI’s guide comparing FCFE and FCFF.


Additional resources

Thank you for reading this section of CFI’s free investment banking book on DCF with terminal value calculation. To keep learning and advancing your career, the following resources will be helpful:

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