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PERPETUITY CASH FLOW EXPLAINED STEP BY STEP



DEFINITION: PERPETUITY IS THE TOTAL SUM OF FREE CASH FLOW OF A BUSINESS FROM A PARTICULAR TIME TO THE END OF IT'S LIFE AT A VERY CONSERVATIVE GROWTH RATE. THIS CASH CAN BE USEFUL TO CALCULATE INTRINSIC VALUE OF THE BUSINESS. THE FORMULA FOR PERPETUITY CASH IS:


IN THE LAST POST ABOUT DISCOUNTED CASH FLOW(DCF) I MENTIONED THAT INSTEAD OF TERMINAL CASH FLOW YOU CAN USE PERPETUITY CASH FLOW TO ESTIMATE THE CASH FLOW OF THE BUSINESS THAT IT CAN BE EXPECTED TO PRODUCE IN IT'S ENTIRE LIFE.

PERPETUITY CASH FLOW IN MORE DETAIL?

WHEN YOU USE DISCOUNTED CASH FLOW, YOU FIGURE OUT THE CASH FLOW OF A BUSINESS FOR 5 OR 10 YEARS, BUT WHAT HAPPENS AFTER THAT? IF YOU OWN A BUSINESS FOR 10 YR, AFTER THE 10 YR YOU CAN EITHER SELL THE BUSINESS OR YOU CAN KEEP THE BUSINESS AND GET CASH FOR AS LONG AS THE BUSINESS LASTS. PERPETUITY CASH FLOW IS THE CALCULATION OF A BUSINESS CASH FLOW FOR IT'S ENTIRE LIFE AFTER THE 10 YR. YOU HAVE TO ADD THIS TO THE CASH YOU GET FOR THE INITIAL 10 YRS TO FIGURE OUT THE TRUE INTRINSIC VALUE OF THE BUSINESS. UNLIKE TERMINAL CASH, PERPETUITY CASH FLOW IS GIVEN BY A PROPER FORMULA WITH FEW ASSUMED QUANTITIES. HERE IS THE FORMULA AGAIN:

FORMULA FOR PERPETUITY CASH FLOW

 
IMPORTANT TERMS

  • PERPETUITY GROWTH %

THIS IS THE GROWTH THAT YOU EXPECT THE COMPANY TO GROW FOREVER AFTER YOUR 10 YR PROJECTIONS. THIS NUMBER NEEDS TO BE VERY CONSERVATIVE, SINCE NO COMPANY, NO MATTER HOW WONDERFUL CAN EVER GROW AT 10% OR MORE FOREVER. AND EVEN IF IT COULD YOU CAN NEVER PREDICT THAT FAR IN THE FUTURE.

  • DISCOUNT %

THIS IS THE RATE AT WHICH WE DISCOUNT THE CASH THAT WE GET. THE DISCOUNT RATE REFLECTS THE UNCERTAINTY, FOR MORE UNCERTAIN BUSINESS USE MORE DISCOUNT RATE AND FOR LOW UNCERTAINTY BUSINESS USE LESS.

  • CASH FLOW(TERMINAL YR)

THIS IS THE CASH FLOW OF THE TERMINAL YEAR FROM YOUR PROJECTIONS OF THE CASH FLOW. IF YOU DON'T HAVE THIS FOR SOME REASON YOU CAN USE THIS FORMULA INSTEAD.



THIS GROWTH RATE IS THE RATE YOU EXPECT THE COMPANY TO GROW FOR THE FIRST 10 YEARS. DO NO CONFUSE IT WITH PERPETUITY GROWTH RATE.

PUTTING IT TO THE TEST

LET'S ASSUME SOME PARAMETER,
  • CASH 10TH YR = 400 MILLION
  • DISCOUNT RATE=10%

WHAT IS THE PERPETUITY GROWTH RATE?

PERPETUITY GROWTH AS I SAID MUST BE EXTREMELY CONSERVATIVE, YOU COULD SET IT TO THE 10 YEAR BOND INTEREST RATE, YOU CAN SET IT TO THE INFLATION RATE OR YOU CAN USE SOME OTHER CONSERVATIVE RATE. I PERSONALLY LIKE TO USE INFLATION RATE.

NOW WE HAVE ALL THE NUMBERS

  • CASH 10 YR = 400 MILLION
  • DISCOUNT RATE = 10%
  • PERPETUITY GROWTH=3%(MY ASSUMPTION JUST FOR THIS PURPOSE)
LET'S CALCULATE



THIS IS THE CASH FLOW YOU GET AFTER 10 YR IF YOU OWN A BUSINESS FOREVER. BUT THIS IS AFTER 10 YR, WE WANT TO DISCOUNT IT AT 10%(YOU CAN USE OTHER RATE) TO KNOW IT'S PRESENT VALUE.

TO DISCOUNT THE PERPETUITY YOU USE THE FORMULA:


AND THERE YOU HAVE IT, THIS IS THE DISCOUNTED PERPETUITY CASH. YOU CAN USE THIS INSTEAD OF TERMINAL MULTIPLE.

IF YOU DID NOT UNDERSTAND, ABOUT ALL THE DISCOUNTED CASH FLOW TALK YOU MIGHT WISH TO CHECK OUT MY OTHER POST ON DISCOUNTED CASH FLOW(DCF).

NOW TO END IT I WILL LEAVE YOU WITH A WARREN BUFFETT QUOTE. HE SAID THIS WHEN HE WAS ASKED 
"WHAT IS YOUR FAVORITE HOLDING PERIOD?"

BUFFETT RESPONDED "MY FAVORITE HOLDING PERIOD IS FOREVER"

SO EVEN THOUGH WARREN BUFFETT DOESN'T HOLD A COMPANY FOREVER BUT HE THINKS LIKE HE IS GOING TO, AND YOU SHOULD TOO. WHENEVER YOU WANT TO MAKE A INVESTING DECISION YOU MUST ASK WHETHER YOU WOULD BE HAPPY TO HOLD THE COMPANY FOR THE NEXT 10 YR, AND IF THE ANSWER IS NO, DON'T INVEST.

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