Which method can be used to predict free cash flows beyond five years in a DCF?

The terminal value multiple or perpetuity method is used to estimate the value of an investment or a company beyond a certain forecast period, typically five years when conducting a Discounted Cash Flow (DCF) analysis. After projecting free cash flows for the initial period (usually five years), analysts need a way to account for the cash flows that will continue to be generated thereafter.

The terminal value approaches provide a method to capture the ongoing value of a business as it continues to operate indefinitely. The perpetuity method, in particular, assumes that free cash flows will grow at a stable rate forever, while the terminal value multiple method applies a multiple based on comparable companies to derive a terminal value based on a final year's projected cash flow.

Both methods allow for a simplification in predicting cash flows beyond the detailed forecast period while recognizing that businesses can continue to generate cash flows beyond the explicit forecast. This assumption is crucial in DCF analysis as it significantly contributes to the overall valuation of the company being assessed.

The other options, such as net present value calculations and internal rate of return estimation, focus on evaluating investment opportunities rather than predicting cash flows beyond the forecast period. Payback period calculations are also fundamentally different as they measure the time it takes to recoup an investment