How is the Terminal Value calculated in a discounted cash flow analysis?

In discounted cash flow (DCF) analysis, the Terminal Value represents the expected value of a business at the end of the forecast period, capturing the majority of the total value being assessed. It is crucial because it acknowledges the cash flows that a business will generate indefinitely beyond the explicit forecast period.

The correct method for calculating the Terminal Value typically involves either the terminal growth multiple method or the perpetuity method.

The terminal growth multiple method estimates Terminal Value by applying an industry multiple (like EBITDA or revenue multiples) to the final year’s projected financial metric. This is based on the idea that companies in a similar industry maintain consistent valuation multiples based on their earnings.

The perpetuity method, on the other hand, projects the final cash flow in the explicit forecast period and assumes it will grow at a constant rate indefinitely. This method uses the Gordon Growth Model, where the cash flow is divided by the discount rate minus the growth rate (FCF / (r - g)). This approach is based on the principle that even after the explicit forecast period, businesses continue to generate cash flows and can grow at a sustainable rate.

Both methods provide a framework for estimating Terminal Value based on underlying cash flows and growth expectations, making this answer accurate in the context of DCF