High Terminal Value in a DCF, Explained

It is a significant concern, though not automatically disqualifying. It means the vast majority of value rests on assumptions about a period you cannot forecast with precision. In this case, because FCF is negative for most of the explicit period, the explicit cash flows contribute little value, making the model essentially a bet on the terminal state.

I would first extend the explicit forecast period until the business reaches steady-state, positive FCF and stable margins, perhaps to 10 or even 15 years. I would then stress-test the terminal growth rate and WACC with sensitivity tables, and cross-check the implied exit multiple against mature software firms. I would also consider using a dividend discount model or a liquidation value if the terminal assumptions seem too heroic.

The high percentage is a warning that the explicit period is not doing its job of capturing the value creation story.

Follow-up pressure:

• If you extend the explicit period to Year 10 and the TV percentage drops to 75%, would you be comfortable? Why or why not?
• What is the absolute minimum explicit forecast length you would accept for this type of company, and how do you justify that number?