Perpetuity Growth Model
- See: Gordon Growth Model
The Perpetuity Growth Model accounts for the value of free cash flows that continue into perpetuity in the future, growing at an assumed constant rate. Also, the projected free cash flow in the first year beyond the projection horizon (N+1) is used. This value is divided by the discount rate minus the assumed perpetuity growth rate: T0 = FCFN+1/(k – g). T0 is the value of future cash flows at a future point in time which is immediately prior to N+1, or at the end of period N, which is the final year in the projection period, k being the discount rate and g being the growth rate. This equation is a perpetuity, which uses a geometric series to determine the value of a series of growing future cash flows.
To determine the present value of the terminal value, one must discount the Terminal Value at T0 by a factor equal to the number of years included in the initial projection period. If N is the 5th and final year in this period, then the Terminal Value is divided by (1 + k)5. The Present Value of the Terminal Value is then added to the PV of the free cash flows in the projection period to arrive at an implied enterprise value.
If the growth rate in perpetuity is not constant, a multiple-stage terminal value is calculated. The terminal growth rate can be negative, if the company in question is assumed to disappear in the future.
Read more about this topic: Terminal Value (finance)
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