Valuating Future Business Cash Flows Using the Gordon Growth Method
When you're valuing a company, you have to assume that that company's cash flows are going to go on through infinity, and the reason is, is because you don't know when the company is going to stop operating. You can't guess when it's going to stop operating.
For example, if you were valuing Ford Motor Company in 1920. Well, it's 2017, it's still here. So, you have to be able to value those cash flows in the future years. And we do have a methodology that is successful in doing this. It's a complicated formula, but it's broken down to be very simple. It's called the Gordon Growth Method and what this does is, when you do a valuation and you have the cash flows for the first five years, let's assume cash flows stabilizes, you need to do the cash flow from year sixth to the future, and that's where this Gordon Growth calculation comes in.
It's simply taking the stabilized cash flow and dividing it by a cap rate. For example, if it was 5% it would be 2,000, and I know a lot of attorneys they question me on this one. "Well, Mr. Bonavito, how can you possibly figure out what the cash flow is 100 years or 200 years in the future?" And I just explain to them that, when you take a cash flow out, the farther you take it out eventually it goes to zero. For example, if you had $2,000, and you take it out 100 years. Let's say, in a 100 years I'm going to get $2,000, the present value of that is $15. If you take $ 2,000 and take it out 200 years, like I'm going to get it in 200 years, the present value of that is 12 cents.
So, what that is saying is if I put 12 cents in the bank and earn 5%, in 2 years I'm going to have $2,000. And that's why this perpetuity of Gordon Growth Method works, because it realizes that when you go far out with the cash the value is eventually going to be zero. So therefore I can estimate what the future cash flow into infinity, because I know it's going to be zero. Anyway, this is pretty complicated subject. So, if you have any questions on this feel free to email me.