Providing a Framework for Testing the Reasonableness of Terminal Period Cash Flow Investments

BVResearch Pro
American Society of Appraisers Business Valuation Review™
Fall 2020 Volume 39, Issue 1 pp. 5-13
Joseph W. Thompson, CFA, ASA
David J. Neuzil, CFA
valuation methods & approaches
gordon growth model, discounted cash flow (DCF)


Whether using the traditional Gordon Growth formula or the value driver formula, it is common for a valuer to neglect testing the reasonableness of the capitalized free cash flow used in determining the terminal value and, therefore, derive a terminal value that is incorrect. This is troubling considering how important the terminal value is when concluding an equity value; the terminal value most often accounts for a majority of the concluded enterprise value when applying the Discounted Cash Flow method. The purpose of this article is to provide a framework for testing the reasonableness of the amount of terminal cash flow that is reinvested to support the operations into perpetuity. In general, there are three potential areas for a company to reinvest into its future operations: (1) net working capital, (2) purchases of property, plant, and equipment (PP&E), and (3) other investments (e.g., research and development [R&D]). Our article provides an overview of a suggested method for analyzing and calculating the appropriate amount of investments in net working capital and PP&E under the Gordon Growth formula. We also provide an example analysis to illustrate potential issues resulting from expensed investments (e.g., R&D) when applying the value driver formula.
Providing a Framework for Testing the Reasonableness of Terminal Period Cash Flow Investments
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