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Amortization should be excluded from terminal value calculations

By Gilbert E. Matthews, CFA

This article is adapted from a forthcoming article in Business Valuation Review entitled “Capital Expenditures, Depreciation and Amortization in the Gordon Growth Model.”

Companies customarily report “depreciation and amortization” as a single line item in their income and cash flow statements. However, valuators should be attentive to the substantive differences between amortization and depreciation, particularly with respect to their impact on terminal value in discounted cash flow calculations.

Amortization and depreciation are both non-cash charges that reduce reported income. Tax-deductible amortization is similar to depreciation in that it reduces both accounting income and taxes, while non-tax-deductible amortization reduces only accounting income. However, there is an important difference between amortization and depreciation that must be recognized by valuators when calculating terminal value. Intangible assets have a limited life and, importantly, differ from fixed assets because specific intangible assets are not systematically replaced in the ordinary course of business. Since amortization, unlike depreciation, does not grow in perpetuity, it should be separately valued in terminal value calculations.

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