Gordon Growth Method is a methodology used in a DCF analysis, which can be used instead of the Terminal Multiple method. The basis behind this method is that it assumes the company will grow and generate free cash flows forever at a consistent rate. This is because you assume that the business will be a going concern and will not go out of business or stop operating after the projection window in the DCF.
Gordon Growth Model - Terminal Value
This consistent rate of growth is usually assumed to be very low and is known as the 'Terminal Growth Rate'. The growth rate must be between the GDP growth rate of the country and the inflation rate of the country. The growth rate must be higher than inflation and less than GDP because it is unreasonable to assume that into perpetuity (forever) that one company will grow faster than the entire economy. If the growth rate is less than inflation, the company will eventually lose its value as its growth is not keeping up with the increasing cost of money.
Gordon Growth Method Formula
Using the Gordon Growth method, the terminal value of the company using a DCF is calculated as:
- Last Year Free Cash Flow x ((1 + Terminal Growth Rate) / (WACC - Terminal Growth Rate))
Discount Period for Gordon Growth Method
Another thing to consider when conducting a DCF using the Gordon Growth method is that the Present Value of the Terminal Value must use the standard discount period rather than the mid-year discount period.
When is it Best to Use the Gordon Growth Method?
For mature and stable companies, it makes sense to use the Gordon Growth Model as you can reasonably predict terminal growth rates. For more unpredictable companies or take out candidates, it would make more sense to use the Terminal Multiple Method.
- Discounted Cash Flow (DCF)
- Earnings Before Interest, Taxation, Depreciation & Amortization (EBITDA)
- Free Cash Flow (FCF)
- Mid-Year Discount
- Terminal Multiple
- Terminal Value (TV)
- Weighted Average Cost of Capital (WACC)