How is the terminal value typically calculated in a DCF analysis?

The terminal value in a discounted cash flow (DCF) analysis is primarily calculated using the perpetuity growth model, which involves establishing a terminal growth rate. This approach reflects the idea that a business will continue to generate cash flows beyond the forecast period, growing at a steady rate indefinitely.

In the perpetuity growth model, the terminal value is calculated by taking the cash flow from the final forecast year and dividing it by the difference between the discount rate and the terminal growth rate. This method captures the value of all future cash flows expected after the explicit forecast period, thus providing a more comprehensive view of a company's long-term value.

The other methods listed in the options such as using a fixed rate of return, multiplying year 5 cash flow by the discount rate, or averaging past cash flows do not accurately reflect the perpetual nature of business cash flows, nor do they consider the growth potential as the business matures. Consequently, these alternatives do not align with best practices in financial valuation and would not yield a defensible estimate of terminal value in a DCF analysis.