Gordon Growth vs Exit Multiple, Explained
The question
Describe the cross-check between the Gordon growth and exit multiple methods. Why is this considered a critical step rather than an optional nicety?
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The answer
Computing one method and back-solving what it implies for the other is a critical step because it immediately exposes whether your assumptions are internally consistent. Terminal value usually represents 60 to 80 percent of total enterprise value, so if these two methods diverge sharply, you are betting the bulk of your valuation on conflicting stories.
I would start with the Gordon growth method, using a long-run sustainable growth rate anchored to nominal GDP, around 2 to 4 percent. Then I divide that terminal value by the terminal year EBITDA to get the implied exit multiple. If that implied multiple is 14 times but my peer set trades at 9 times, I know my growth rate is too high or my discount rate is too low.
Conversely, if I start with an exit multiple and back out the implied perpetuity growth rate, an 8 percent result would signal the multiple is too rich for a sustainable long-run rate. This cross-check is not optional because without it, the two methods can produce wildly different values without you realizing one assumption contradicts the other.
It is the single most important sanity check that ties the DCF back to real market observations and keeps the entire model grounded.
DCF timeline
| Line item | Year 1 | Year 2 | Year 3 | Year 4 | Year 5 |
|---|---|---|---|---|---|
| Free cash flow | 50 | 54 | 58 | 63 | 68 |
| PV of free cash flow | 45 | 45 | 44 | 43 | 42 |
| Terminal value (Year 5 exit) | 1,001 |
| PV of terminal value | 621 |
| Implied enterprise value | 840 |
Also asked as
- What share of total DCF enterprise value does terminal value typically represent, and why does that matter for how you present a DCF's output?
- Write the Gordon growth terminal value formula and the exit multiple terminal value formula. What does each require to be a valid, sensible calculation?
- Why must the perpetuity growth rate g be less than WACC? Explain both the mathematical and economic reasons.
- Terminal-year FCF is $60mm, WACC is 10%, and g is 2.0%. Compute the terminal value as of the terminal year and its present value if the terminal year is year 6.
- Explain what a 'fade period' is and why a model that jumps directly from a high explicit-period growth rate to a low terminal growth rate without one might be understating or overstating value.
- A cyclical company's terminal year happens to land at a cyclical peak. Explain the specific error this introduces into an exit-multiple terminal value calculation and how you would correct for it.
- Terminal-year EBITDA is $220mm and terminal-year FCF is $130mm. WACC is 8.5%. Peers trade at 10x-11x EV/EBITDA. Using Gordon growth with g=3.5%, compute the terminal value and its implied exit multiple. Is the assumption defensible? If not, propose a corrected g and recompute.
- A company's reinvestment rate (CapEx plus working capital investment as a share of NOPAT) in its explicit forecast period is 40%, supporting 12% annual growth. In the terminal year, the model assumes growth drops to g=2.5% but leaves the reinvestment rate at 40%. Explain precisely why this understates terminal-year free cash flow, and describe how you would correct the reinvestment assumption using the relationship between g, ROIC, and reinvestment rate.
- You are asked to defend a terminal value where Gordon growth (g=3.0%, WACC=9%) and an exit multiple of 11x on peers trading at 9x both appear in the same model, and they do NOT reconcile: Gordon growth's implied multiple is 13.5x. Walk through, step by step, how you would diagnose which input (WACC, g, or the chosen exit multiple) is most likely the source of the inconsistency, and how you'd defend your final choice to an MD who wants a single terminal value in the model.
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The rest of this topic
The DCF: cash flow, discount rate, terminal value