Why is terminal value critical in a DCF valuation?

The significance of terminal value in a discounted cash flow (DCF) valuation lies in its role in representing the future value of a business beyond the explicit forecast period. In a typical DCF analysis, detailed cash flow estimates are made for a finite number of years—often five to ten—after which estimating individual cash flows becomes increasingly uncertain. The terminal value estimates the value of the business at the end of this forecast period, assuming it continues to operate indefinitely. This is important because a substantial portion of the total valuation can come from this terminal value, particularly for businesses expected to grow steadily after the forecast period.

By considering the terminal value, analysts capture the ongoing potential of the business, acknowledging that companies do not just have value during the forecast years, but also beyond them. This comprehensive view ensures that the DCF valuation reflects the long-term sustainability and earning potential of the business.