Valuation Techniques: Discounted Cash Flow, Earnings Quality, Measures of Value Added, and Real Options

TERMINAL VALUE

Once the periodic cash flows have been estimated and the discount rate has been chosen, the first term in equation (2) of Figure 5.1 can be calculated. The last piece of information needed to complete the discounted-cash-flow calculation is the terminal value. As stated earlier, the terminal value is the value of the company in year t as if it were to be sold in year t. There are several ways to estimate terminal value.

The most common method is to “capitalize” the cash flow expected in the next period (period “t + 1”). In equation (1), if the growth rate of the cash-flow stream is constant over time periods one to infinity, and if the growth is small relative to the discount rate, equation (1) simplifies to:

where

CF1 = cash flow in period l (the next period)

i = discount rate

g = constant growth rate from time t = 1 to time t = infinity

This formula is essentially the Gordon-Shapiro Model. In business appraisal, it is generally shown as follows:

where

Capitalization Rate = Discount Rate − Growth

The cash flow used in the formula is the next year’s cash flow. The capitalization rate is risk adjusted and growth adjusted. The formula is that for single-period capitalization. The cash flow is assumed to last forever, as is the growth. The terminal value given by the ...