In a prior post we mentioned the three basic components of a discounted cash flow (“DCF”) valuation analysis — cash flow projections, a discount rate, and a terminal value — and explained how to calculate one of those components, the discount rate. In this post, we tackle another component, the terminal value.

In a typical DCF analysis, the appraiser will discount to present value the cash flows that the company projects it will receive over a discrete period. Because most companies’ financial projections forecast only a few years into the future, usually five years at most, an appraiser must add a “terminal value” to the projected cash flows in order to value all of the company’s future income beyond the initial near-term projections.

One common method applied by the courts in calculating that terminal value is the Gordon Growth Model. The first step of the Gordon Growth Model is to determine the company’s expected income for the year immediately following the initial discrete projection period. A “perpetuity growth rate” is applied to that projection income to estimate the company’s long-term growth. The perpetuity growth rate is determined based on a number of considerations, such as the company’s historical and expected future performance, the rate of inflation, and other factors. That amount is then capitalized using a capitalization rate that is equal to the discount rate minus the perpetuity growth rate. Thus, if Company A has a cost of capital of 10%, is expected to make \$10,000,000 in normalized economic income in the year following its discrete projection period and is expected to grow past the discrete projection period at a rate of 5%, its terminal value would be \$210,000,000, calculated as follows:

 \$10,000,000 * (1 + 0.05) =      \$210,000,000 0.10 – 0.05

Because the terminal value is calculated as of the end of the discrete projection period, it must be further discounted to present value as of the valuation date.

A common misconception when calculating terminal value is that by applying a “perpetuity growth rate,” the court is assuming that a company will grow into perpetuity. As a practical matter, the perpetuity growth rate merely forecasts the company’s long-term growth, not its literal perpetual growth. When discounted to present value, most of a company’s terminal value is typically realized within the first ten to twenty years following the end of the discrete projection period.