There are different methods to estimate terminal value in a DCF valuation. You can estimate terminal value in a DCF valuation using any of the common methods: perpetual growth rate, multiples of earnings, cash flows, or revenues, or less common methods such as orderly liquidation value; or a fire sale value. If you use the perpetual growth rate method to arrive at the terminal value, you will need a cash flow estimate. What cash flow value do use to calculate terminal value if you are using the perpetual growth method?
In a DCF valuation model, you forecast cash flows for the forecast period of 3, 5 or 10 years. If you assume the final year of the forecast period is defined as year t, then you must use the year t+1 cash flows.
PV of a Growing Perpetuity
You use the cash flows from year t+1 because the terminal value formula is based on the Present Value of a Growing Perpetuity formula. The present value of a growing perpetuity is equal to the next year’s cash flows divided by the discount rate minus the growth rate.
Cash flows for year t+1
The cash flow for year t+1 is not built or estimated like the cash flows for the forecast period in a DCF valuation. The cash flow for year t+1 is estimated based on the detailed estimate of cash flows of the last year of the forecast period. The cash flow for year t+1 is arrived at by growing the last cash flow of the forecast period by the terminal growth rate. Terminal value is a central component of DCF valuation.