Avoid this inconsistency with the terminal value

BVWireIssue #204-1
September 11, 2019

valuation methods & approaches
gordon growth model, discounted cash flow (DCF), terminal value

Terminal value calculations use a perpetuity model that, when using Gordon growth, assumes cash flows occur at the end of each year. But, if you are valuing the subject company on a midperiod basis, you are assuming cash flows during the discrete period occur effectively at the middle of the year. The result is a disconnect: The perpetuity model assumes end-of-year convention, but the valuation of the discrete period is based on a midperiod convention. To fix this internal inconsistency, the undiscounted terminal value that assumes cash flows are received at the end of each year can be discounted by a period that is six months (N - 0.5) before the discrete projection period ends, advises Michael Vitti (Duff & Phelps), during a recent webinar. It can also be fixed by increasing the undiscounted terminal value to reflect an additional six-month return at the same rate as the discount rate. Of course, when the valuation is done using the end-period convention, there’s no disconnect, so N years should be used for the discount period. Likewise, a terminal value based on an exit multiple must also be discounted by the length of the discrete period (N years) because we assume the business is sold at the end of the discrete period. He co-presented the webinar, Terminal Value: A Perpetual Issue in Valuation, with Seth Fliegler (Duff & Phelps). A recording is available if you click here.
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