What does terminal value represent in a valuation context?

Terminal value plays a critical role in valuation, particularly in the context of discounted cash flow analysis. It represents the value of a business's cash flows beyond the explicit forecast period, extending indefinitely into the future. By capturing the present value of all future cash flows expected to be generated after the initial projection, terminal value addresses the reality that businesses typically do not have a defined end date.

In financial modeling, after predicting a firm’s cash flows for a specific number of years, the terminal value is calculated to account for the value generated thereafter. This is essential since a significant portion of a company's total value often lies in the cash flows beyond the initial forecast period. The two primary methods for estimating terminal value are the Gordon Growth Model (or perpetuity growth method) and the exit multiple method. Both approaches provide insight into how a business might perform indefinitely and set the foundation for valuation assessments.

The other choices do not accurately capture this aspect of terminal value. The projected cash flows from the start of the projection refer to initial forecasts rather than the perpetuity aspect. The total revenue over the analysis period does not encompass the concept of cash flows extending indefinitely, and a company’s book value at the end of the projection strictly pertains to the accounting perspective rather than the valuation