I always had interesting conversations around the assumption and concept of terminal value (TV) in the valuation and financial modelling classes.

The above formula on estimating the terminal value of a company 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.

The ecosystem of companies and their life-cycles today are very different from 40-50 years ago.

Take for instance Nokia--the phone company only had a seven-year life cycle. Research In Motion, the company behind the Blackberry lasted for no more than two decades. General Electric is probably one of the closest example of how a company can last for many decades 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 based on five and ten year plans. Although some founders have a longer term view of how they envision the business to be, these are mostly aspirational, some might even say crazy.

To make a call on a business over a 20-year horizon is almost unfathomable to the human mind. Most of us can't handle outcomes lasting beyond a few decades. To tie up the loose ends in when it comes to valuing businesses, economists simplify this using mathematics. But in the process, they disregard the ups and downs of businesses, which is a practical consideration for fund managers who need to allocate capital under a finite time. After all, the terminal value is ultimately driven by being able to liquidate the underlying asset at the right time.

The perpetual growth model also ignores the effects from secondary markets--investors and individuals who are prone to speculating on a company's price tag. This opens up an alternative scenario whereby an alternate scenario exists to allow investors to flip their positions to another party for a quick profit.

The key here is communicating the right narrative to potential buyers. Because of this, telling stories become even more important especially when it comes to visualizing how a company performs beyond the typical five-ten year timeframe. After all, calculations involving terminal value have shown that 60-80% of a firm's total value is attributed on the discount factor rate and assumptions around the perpetual growth rate,

This seems very paradoxical given that we spend a significant time rigorously validating the company's revenue and free cash flows over the initial forecast period, only to chuck most of the terminal value into a mathematical black box .

The 2% growth rate which has been widely applied in terminal value calculation were originated in New Zealand at a meeting with various central banks in 1989. According to the then central bank chief 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 incorporate this into their policy goals to balance economic growth, wages and unemployment among other things. However, 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 the long-term growth rate assumption is for arriving at a company's terminal value.

During my earlier days in banking, we would get into healthy debates around the weighted average cost of capital (WACC) and the terminal value. Some of those discussions were also deemed as a test of your corporate finance knowledge. But most of the time, it was because a credible fair value estimate was required as part of the report deliverable. In the real world, there is no such thing as a fair value. There are no right answers for arriving at 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.

When it comes to estimating the discount rate for valuing a business, perhaps the more appropriate question is:

What kind of returns are you expecting?

It sounds like "plucking" a number from thin air, which is technically not incorrect when you think about it.

If you are an investor considering whether to put money in a early stage start-up, this could be anywhere north of 35% to compensate for the high probability of failure. For private equity firms, rates of return could be between 25-35% whereas large institutional investors might expect 9-15% with public equities with a nearly 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). The only difference with the CAPM is that it reflects the assumption that investors to be fully diversified in the equities market.

Investors who use their own yardstick for the discount rate and can't get to the valuation they want, generally try to re-validate the cash flow projections or find alternate ways to grow the business in order to make a case for the investment.

So don't get too caught up with economic and valuation models. They are only meant to be guidelines for operating in the real world. And as the dynamics of the real world change, so must our understanding and application of corporate finance.