Why is establishing a terminal value important in financial modeling?

Establishing a terminal value is crucial in financial modeling because it allows analysts to capture the long-term growth expectations of a company beyond the explicit forecast period, which typically covers a limited number of years. The terminal value represents the present value of all future cash flows that a business is expected to generate indefinitely after the forecast period ends. This value is tied closely to the assumptions made about the company’s growth rate and market stability, making it essential for understanding its overall potential.

By estimating the terminal value, analysts can incorporate expectations about how the company will perform in the long term, which significantly contributes to the overall valuation in discounted cash flow (DCF) analysis. This captures the value of a company's perpetuity, reflecting both its sustainability and projected growth, providing a more comprehensive view than relying solely on forecasted cash flows for a limited time.