Why is the final year significant in a DCF projections period?

The final year in a DCF (Discounted Cash Flow) projections period is significant primarily because it is where the terminal value is calculated. In a DCF analysis, the projections typically cover a finite number of years, usually 5 to 10, after which it becomes difficult to forecast free cash flows accurately. To address this, the terminal value represents the present value of all future cash flows beyond the explicit forecast period, reflecting the company's value at the end of that forecast.

Calculating the terminal value is crucial as it captures a substantial portion of the total valuation derived from the DCF. The method for calculating the terminal value can vary, commonly using either the perpetuity growth model or the exit multiple approach. This final year acts as a bridge between the forecasted cash flows and the long-term sustainability of the business, making it a critical component of the overall valuation.

Recognizing the significance of the final year allows analysts to derive a more accurate valuation of the company by emphasizing not just the immediate cash flows, but also the growth and profitability expectations extending beyond the analytical horizon. This focus on terminal value in the final year underscores its importance in the DCF methodology.