What is the Gordon Growth Terminal Value formula?

What is the Gordon Growth Terminal Value formula?

• A. Terminal Value = Year 5 Free Cash Flow * (1 + Growth Rate) / (Discount Rate - Growth Rate)
• B. Terminal Value = Year 5 EBITDA * (1 + Growth Rate) / (Discount Rate - Growth Rate)
• C. Terminal Value = Year 5 Revenue * Growth Rate
• D. Terminal Value = Year 5 Free Cash Flow / (Discount Rate - Growth Rate)

Answer: (A)

When valuing via a discounted cash flow, the terminal value is the value of all future cash flows assuming they grow at a constant rate forever. At the end of year 5, you value the next year’s free cash flow as part of a growing perpetuity. If FCF5 is the free cash flow in year 5, then FCF6 = FCF5 × (1 + g). The value of all cash flows from year 6 onward, as of the end of year 5, is FCF6 / (r − g) = FCF5 × (1 + g) / (r − g). So the terminal value at the end of year 5 is Terminal Value = Year 5 Free Cash Flow × (1 + Growth Rate) / (Discount Rate − Growth Rate). This uses free cash flow (not EBITDA or revenue) and properly accounts for the perpetual growth. The other forms either base the value on the wrong metric or omit the growth factor, which doesn’t reflect a growing perpetuity.

When valuing via a discounted cash flow, the terminal value is the value of all future cash flows assuming they grow at a constant rate forever. At the end of year 5, you value the next year’s free cash flow as part of a growing perpetuity. If FCF5 is the free cash flow in year 5, then FCF6 = FCF5 × (1 + g). The value of all cash flows from year 6 onward, as of the end of year 5, is FCF6 / (r − g) = FCF5 × (1 + g) / (r − g). So the terminal value at the end of year 5 is Terminal Value = Year 5 Free Cash Flow × (1 + Growth Rate) / (Discount Rate − Growth Rate). This uses free cash flow (not EBITDA or revenue) and properly accounts for the perpetual growth. The other forms either base the value on the wrong metric or omit the growth factor, which doesn’t reflect a growing perpetuity.