{"id":21768,"date":"2020-01-08T18:56:11","date_gmt":"2020-01-08T23:56:11","guid":{"rendered":"https:\/\/breakingintowallstreet.com\/biws\/?post_type=biws_kb&#038;p=21768"},"modified":"2024-08-10T23:27:08","modified_gmt":"2024-08-11T04:27:08","slug":"dcf-terminal-value","status":"publish","type":"biws_kb","link":"https:\/\/breakingintowallstreet.com\/kb\/discounted-cash-flow-analysis-dcf\/dcf-terminal-value\/","title":{"rendered":"DCF &#8211; Terminal Value &#8211; Gordon Growth Method Intuition (24:35)"},"content":{"rendered":"<style>.enteremail__large--inline{margin:60px auto!important}<\/style>\n<div id=\"ez-toc-container\" class=\"ez-toc-v2_0_81 counter-flat ez-toc-counter ez-toc-grey ez-toc-container-direction\">\n<div class=\"ez-toc-title-container\">\n<p class=\"ez-toc-title\" style=\"cursor:inherit\">DCF - Terminal Value - Gordon Growth Method Intuition<\/p>\n<span class=\"ez-toc-title-toggle\"><\/span><\/div>\n<nav><ul class='ez-toc-list ez-toc-list-level-1 ' ><li class='ez-toc-page-1'><a class=\"ez-toc-link ez-toc-heading-1\" href=\"https:\/\/breakingintowallstreet.com\/kb\/discounted-cash-flow-analysis-dcf\/dcf-terminal-value\/#Gordon_Growth_Method_Intuition\">Gordon Growth Method Intuition<\/a><\/li><li class='ez-toc-page-1'><a class=\"ez-toc-link ez-toc-heading-2\" href=\"https:\/\/breakingintowallstreet.com\/kb\/discounted-cash-flow-analysis-dcf\/dcf-terminal-value\/#The_Algebra_Behind_Gordon_Growth\">The Algebra Behind Gordon Growth<\/a><\/li><li class='ez-toc-page-1'><a class=\"ez-toc-link ez-toc-heading-3\" href=\"https:\/\/breakingintowallstreet.com\/kb\/discounted-cash-flow-analysis-dcf\/dcf-terminal-value\/#Gordon_Growth_Method_Summary\">Gordon Growth Method Summary<\/a><\/li><\/ul><\/nav><\/div>\n\n<h2><span class=\"ez-toc-section\" id=\"Gordon_Growth_Method_Intuition\"><\/span>Gordon Growth Method Intuition<span class=\"ez-toc-section-end\"><\/span><\/h2>\n<p>The basic intuition here is that we can pay:<\/p>\n<h3>Annual Free Cash Flow \/ Discount Rate<\/h3>\n<p>For an investment, if the cash flow stays the same each year and we&#8217;re targeting a specific yield on our investment (known as the &#8220;discount rate&#8221; in a <a href=\"https:\/\/www.mergersandinquisitions.com\/dcf-model\/\" target=\"_blank\" rel=\"noopener noreferrer\">DCF model<\/a>).<\/p>\n<p>Why?<\/p>\n<p>Think about if you could make an investment that earned $100 in cash flows each year.<\/p>\n<p>You&#8217;re targeting a 10% yield on your investment.<\/p>\n<p>How much could you pay for it?<\/p>\n<p>$1,000, because $1,000 * 10% = $100 in cash flows each year.<\/p>\n<p>You can use the NPV function in Excel with $100 in cash flow each year (e.g., =NPV(10%, Long series of $100 you&#8217;ve entered in consecutive cells)) to verify this.<\/p>\n<p>The NPV, or &#8220;<a href=\"https:\/\/breakingintowallstreet.com\/kb\/finance\/net-present-value\/\" target=\"_blank\" rel=\"noopener\">net present value<\/a>,&#8221; IS this number &#8211; what we could afford to pay for a series of cash flows at a given yield we&#8217;re targeting.<\/p>\n<div class='code-block code-block-2' style='margin: 8px 0; clear: both;'>\n<div class=\"kb-adinsert-modal\">\n    <div class=\"kb-adinsert-top\">\n      <div class=\"media\">\n          <img decoding=\"async\" class=\"alignnone size-full wp-image-28448\" src=\"https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2024\/04\/24164120\/adv-fm-tile.png\" alt=\"PowerPoint Pro\" width=\"128\" height=\"128\" \/>\n      <\/div>\n      <div class=\"content\">\n          <h3>Master Financial Modeling for Investment Banking With <strong>BIWS Core Financial Modeling<\/strong><\/h3>\n      <\/div>\n    <\/div>\n    \n    <div class=\"full_text\">\n    \t<ul>\n        \t<li>\n            \t<h4>Become a financial modeling pro<\/h4>\n              <p>158 videos, detailed written guides, Excel files, quizzes, and more<\/p>\n\t\t\t    <\/li>\n          <li>\n          \t<h4>Complete 10+ detailed global case studies<\/h4>\n            <p>These include both the theory and the practical applications<\/p>\n\t\t\t    <\/li>\n          <li>\n          \t<h4>Prepare for your internship or full-time job<\/h4>\n            <p>Gain the skills you need to \u201chit the ground running\u201d on Day 1\n\n<\/p>\n\t\t\t  <\/li>\n      <\/ul>\n        \n      <a class=\"cta-link orange-button-medium\" href=\"https:\/\/breakingintowallstreet.com\/core-financial-modeling\/\" target=\"_blank\">Full Details<\/a>\n      \n      <a class=\"cta-link orange-button-medium bg-blue\" href=\"https:\/\/biws-support.s3.us-east-1.amazonaws.com\/Course-Outlines\/Core-Financial-Modeling-Course-Outline.pdf\" target=\"_blank\" rel=\"noopener\">Short Outline<\/a>\n    <\/div>\n<\/div><\/div>\n\n<p>The Intuition &#8212; Growth in Cash Flows<\/p>\n<p>This works fine if there&#8217;s no growth and the cash flows stay the same each year, but what if they&#8217;re growing?<\/p>\n<p>Well, in that case we can afford to pay MORE than that $1,000 and still get the same 10% yield&#8230; because there&#8217;s growth!<\/p>\n<p>Specifically, we can now pay:<\/p>\n<h3>First Year Free Cash Flow \/ (Discount Rate &#8211; FCF Growth Rate)<\/h3>\n<p>for this investment.<\/p>\n<p>In the Terminal Value calculation, that &#8220;First Year Free Cash Flow&#8221; is written as Final Year Projected Free Cash Flow * (1 + FCF Growth Rate)&#8230;<\/p>\n<p>&#8230;because we&#8217;re going one year BEYOND the end of our projection period in the model.<\/p>\n<p>By *subtracting* the growth rate in the denominator, we make the denominator smaller&#8230; which makes the amount we can pay significantly bigger.<\/p>\n<p>If cash flows grow more quickly, the denominator gets even smaller and the entire number gets even bigger.<\/p>\n<p>If cash flows grow more slowly, the denominator gets bigger and the entire number gets smaller.<\/p>\n<p>Let&#8217;s say the cash flows start at $100 and grow by 3% per year.<\/p>\n<p>We&#8217;re targeting a discount rate of 10%.<\/p>\n<p>The NPV here would be $1,429, or $100 \/ (10% &#8211; 3%).<\/p>\n<p>Why does this work?<\/p>\n<p>Why can we pay $1,429 and still get that 10% yield?<\/p>\n<p>Think about it like this&#8230;<\/p>\n<p>The yield in Year 1 is is $100 \/ $1429, or 7.0%<\/p>\n<p>But then by Year 5, it&#8217;s $113 \/ $1429, or 7.9%.<\/p>\n<p>And then as you keep going, the Yield gets higher and higher&#8230; because we have growth.<\/p>\n<p>By Year 20, it&#8217;s $175 \/ $1429, or 12.3%.<\/p>\n<p>So, over all those years into the future, the average comes out to 10%&#8230; because it&#8217;s LESS than 10% in the early years and greater than 10% much later on.<\/p>\n<p>So the weighted average, factoring in the <a href=\"https:\/\/breakingintowallstreet.com\/kb\/finance\/time-value-of-money\/\" target=\"_blank\" rel=\"noopener\">time value of money<\/a>, still comes out to that 10% yield we were targeting.<\/p>\n<h2><span class=\"ez-toc-section\" id=\"The_Algebra_Behind_Gordon_Growth\"><\/span>The Algebra Behind Gordon Growth<span class=\"ez-toc-section-end\"><\/span><\/h2>\n<p>Please see the video for this part &#8211; it&#8217;s almost impossible to explain in text form.<\/p>\n<h2><span class=\"ez-toc-section\" id=\"Gordon_Growth_Method_Summary\"><\/span>Gordon Growth Method Summary<span class=\"ez-toc-section-end\"><\/span><\/h2>\n<p>We care about this because everyone uses this formula to calculate Terminal Value in a DCF, but hardly anyone explains where it comes from.<\/p>\n<p>The basic idea is that you can pay more for a company that&#8217;s growing its cash flows than for one that&#8217;s NOT growing its cash flows.<\/p>\n<p>And to represent that, you use the formula:<\/p>\n<p>Final Year, Projected Period Free Cash Flow * (1 + FCF Growth Rate) \/ (Discount Rate &#8211; FCF Growth Rate)<\/p>\n<p>To approximate the amount you could pay for the Free Cash Flows in the Terminal Period &#8211; which is the Terminal Value in a DCF.<\/p>\n","protected":false},"excerpt":{"rendered":"<p>We review the *intuition* behind the Gordon Growth Formula used to calculate Terminal Value in a Discounted Cash Flow (DCF) analysis.<\/p>\n","protected":false},"featured_media":21774,"template":"","class_list":["post-21768","biws_kb","type-biws_kb","status-publish","has-post-thumbnail","hentry","kb_category-discounted-cash-flow-analysis-dcf"],"acf":[],"_links":{"self":[{"href":"https:\/\/breakingintowallstreet.com\/wp-json\/wp\/v2\/biws_kb\/21768","targetHints":{"allow":["GET"]}}],"collection":[{"href":"https:\/\/breakingintowallstreet.com\/wp-json\/wp\/v2\/biws_kb"}],"about":[{"href":"https:\/\/breakingintowallstreet.com\/wp-json\/wp\/v2\/types\/biws_kb"}],"wp:featuredmedia":[{"embeddable":true,"href":"https:\/\/breakingintowallstreet.com\/wp-json\/wp\/v2\/media\/21774"}],"wp:attachment":[{"href":"https:\/\/breakingintowallstreet.com\/wp-json\/wp\/v2\/media?parent=21768"}],"curies":[{"name":"wp","href":"https:\/\/api.w.org\/{rel}","templated":true}]}}