What is terminal value in a discounted cash flow model, and which methods can be used to calculate it?

• A. Terminal value estimates cash flows beyond the explicit forecast; use perpetuity growth or exit multiples; discount back at rate.
• B. Terminal value is the present value of the explicit forecast.
• C. Terminal value is the initial investment.
• D. Terminal value is optional and not used.

Answer: (A)

Terminal value captures the value of all cash flows that occur after the explicit forecast period, since in reality a business continues beyond the forecast horizon even if we don’t model every year. This continuing value is essential because it often accounts for a large portion of the total value in a discounted cash flow model.

There are two standard ways to estimate terminal value. The perpetuity growth method assumes cash flows grow at a constant rate forever, so the terminal value is calculated as TV = FCF_{t+1} / (r − g) (or equivalently the final forecast year cash flow times (1+g)/(r−g)). The exit multiple method estimates terminal value by applying an industry-standard multiple to a final-year metric (like EBITDA or EBIT), yielding TV = multiple × metric at the end of the forecast.

Once the terminal value is computed, it is discounted back to present value at the chosen discount rate (often the weighted average cost of capital) and added to the present value of the explicit forecast to determine overall enterprise value.