What should the terminal value primarily reflect in a DCF model?

In a discounted cash flow (DCF) model, the terminal value is meant to represent the value of a company’s cash flows beyond the explicit forecast period, extending indefinitely into the future. The correct understanding is that the terminal value will primarily reflect what the cash flows would look like at the end of the forecast period.

The rationale for the answer relating to the present value of cash flows during the last forecast year is that this cash flow serves as a critical input to estimate the terminal value using a perpetuity growth model or an exit multiple approach. These approaches rely on projecting the company's cash flows based on the final year of the forecast and determining how much those cash flows would generate into the future.

This indicates that at the end of the explicit forecasting period, the cash flows are assumed to grow at a stable rate, and the value derived from these cash flows represents the company’s continuing operations far beyond the forecast horizon. The present value of these estimated future cash flows is then discounted back to the present to determine their worth today.

Therefore, the focus of the terminal value is on reflecting the cash flows at the last forecast year and their potential growth, emphasizing the vital role these projections play in establishing the overall valuation of the company.