Which method is recommended for calculating terminal value in a DCF?

The recommended methods for calculating terminal value in a Discounted Cash Flow (DCF) analysis are the Gordon Growth method and the Multiples method.

The Gordon Growth method, also known as the perpetuity growth model, assumes that free cash flows will continue to grow at a stable rate indefinitely after the forecast period. This is particularly appropriate for mature companies with steady cash flows and growth rates that can be estimated reliably over the long term. The formula used for this method is based on the projected cash flow beyond the explicit forecast period divided by the difference between the discount rate and the growth rate.

On the other hand, the Multiples method entails applying an industry comparable multiple (such as EV/EBITDA) to the estimated financial metric at the end of the projection period to derive the terminal value. This method is often used when it’s easier to obtain market data on similar companies rather than making assumptions about perpetual growth rates.

Both of these methods are favored due to their ability to provide a reliable estimate of terminal value, which is a crucial component of a DCF as it accounts for the bulk of the total valuation in many cases.