Gilbert E. Matthews, CFA
This article discusses two common errors when calculating terminal value using the Gordon growth model-overstating depreciation in relation to capital expenditures and overlooking amortization’s time limits. For a growing company, normalized capital expenditures must be materially higher than depreciation. Amortization of intangible assets is worth the present value of the future tax benefits and should be excluded from the base on which terminal value is calculated. Instead, the present value of the benefits should be added to enterprise value. Similar adjustments should be made for tax-loss carry forwards, limited-life royalties, and other limited-life income and expenses.
The validity of a discounted cash flow (DCF) calculation necessarily depends on a sound determination of terminal value. Terminal value accounts for well over half of the calculated value in most DCF analyses. It may be determined either by a growth model (the method preferred by most authors) or by applying a multiple to projected EBITDA1 (preferred by a majority of investment bankers2) or net income. This article discusses two common errors when calculating terminal value using a growth model:
- overstating depreciation deductible for US tax purposes in relation to capital expenditures (capex), and
- overlooking the fact that the amortization of most intangible assets for US tax purposes inherently has a fifteen-year limited life.