I always have had interesting conversations around the assumption and concept of terminal value (TV) in my valuation and financial modelling classes.
The above formula is an extension of the Gordon Growth Model - an economic model developed by Myron Gordon, a professor from the University of Toronto, a key assumption being that a company lasts forever.
Corporate life cycles and the secondary market
The ecosystem of companies and their life-cycles today are very different from 40-50 years ago. Nokia came and went in 7 years. BlackBerry (RIM) lasted for no more than two decades. GE is probably one of the more closely relevant examples of how a company lifecycle could run its course for a relatively longer time before being dismantled into three separate segments in 2021. But I think most companies today don't enjoy that kind of legacy.
Many corporate decisions are made using five and ten year plans. While founders may even have a longer term view of how they envision the business to be, these are mostly aspirational, some might even say fluffy. To make a call on a business over a 20-year horizon is almost unfathomable. Most human minds can't handle outcomes beyond a few decades, and as a result, economists try and simplify this scientifically, and in the process, disregard the cyclical nature of businesses - which is a practical consideration for most investors with a finite professional life. After all, the terminal value is only as tangible as the ability to monetise the underlying asset at the right time.
The perpetual growth model also ignores the effects from secondary markets - investors and individuals that are prone to speculating on a company's value, taking positions both on the stock and derivative instruments such as CFDs and options.
This opens up an alternative scenario: Instead of holding on to a share to perpetuity, there is a choice to flip their position for a quick profit, as long as the equity story continues to hold up. This makes both the use of market multiples and communicating the right narrative even more relevant.
The 2% perpetual growth rate
Besides, as we all know, casting the remaining cashflows into terminal value after the forecast period usually implies that you are basing 60-80% of the total firm value on the discount rate and the perpetual growth rate, which to me seems very paradoxical given that we spend a significant amount of time working out the company's revenue and free cash flows, only to chuck it into a mathematical black box.
Interestingly, the so-called 2% rate widely used in our perpetual growth models originated from New Zealand in 1989 when the reserve bank codified its monetary policy.
According to the then central bank chief, he said that this was “a chance remark" and that the figure was "plucked out of the air to influence the public’s expectations”. The US would later on reference and incorporate this into their policy goals to balance economic growth, wages and unemployment among other things. If you try and communicate this with someone sitting in China or parts of emerging Asia, no one would have a clue what you were talking about. Most people in Asia simply don't care about what long-term growth rate you use for arriving at the terminal value.
Don't get so caught up in economic and finance theories
We used get into hours of academic discussions over the WACC and terminal value during my earlier days in banking. Some of it was deemed as a test of your corporate finance knowledge. Other times it was because a valuation report required the loose ends to be tied in order to arrive at a fair value, or that we needed to demonstrate some form of credibility in the delivery of our report.
The reality is: In the M&A world, there is no such thing as a fair value. No correct answer for the WACC. There are only astute decision makers and those who are afraid to get caught on the wrong side of the outcome. Calculating the cost of capital or terminal growth rate with precision is only crucial either from a financial reporting point of view or only if you expect someone important to be challenging these assumptions specifically.
"What is then the right discount rate to use?" Perhaps the more appropriate question is: What kind of returns are you expecting? If you are evaluating a start-up, this could be anywhere north of 35%. For private equity firms, the rates could range between 15-25%. Institutional investors of public equities could expect 9-15% with zero tolerance for failure.
Simply put: The discount rate is mostly investor-driven - which if you think about it, very similar to the CAPM (Capital Asset Pricing Model), only that the CAPM assumes the investors to be fully diversified. Investors who use their own yardstick for the discount rate and can't get to the valuation they want, generally try to manipulate the cash flows or find ways to "create value" in order to establish a case for the investment.
Don't get so caught up with economic and valuation theories. They are only as important as much as you can use them in the real world. As the dynamics of the real world change, so must our understanding and application of finance.