How is terminal value typically calculated?

The terminal value is a crucial component in the discounted cash flow (DCF) analysis, as it represents the value of a business at the end of the explicit forecast period. It reflects the idea that a company will continue to generate cash flows beyond the explicit forecast horizon. The two primary methods for calculating terminal value are the Gordon Growth Model (also known as the perpetuity growth model) and the Exit Multiple method.

Using the Gordon Growth Model involves estimating the future cash flows of the business and assuming that they will grow at a stable rate indefinitely beyond the forecast period. This method calculates the terminal value by projecting the last free cash flow in the explicit forecast and dividing that by the difference between the discount rate and the perpetual growth rate.

The Exit Multiple method, on the other hand, estimates terminal value based on applying a multiple (such as EBITDA, EBIT, or revenue) that is derived from comparable company analysis to the financial metric of the business at the end of the forecast period. This approach reflects the market's valuation of similar companies at that point in time.

Both methods are widely accepted in financial modeling and are essential for arriving at a comprehensive measure of a firm's value when conducting a DCF analysis. Therefore, the choice that identifies these two methods as