Investors can use several different formulas when calculating terminal value for a firm, but all of them allow – at least in theory – for the growth rate to generate a negative terminal value. This would occur if the cost of future capital exceeded the assumed growth rate. In practice, however, negative terminal valuations don’t actually exist for very long. A company’s equity value can only realistically fall to zero; any remaining liabilities would be sorted out in a bankruptcy proceeding.
Since a company’s terminal value is calculated as a perpetuity (extended forever into time), it would have to be heavily subsidized by the government or have endless cash reserves for the equation to support a negative growth rate.
The Use of Terminal Values and Growth Rate Assumptions
The terminal value of a company is a rough approximation of its future value at some date beyond which specific cash flows cannot be estimated. Several models exist to calculate terminal value, including the perpetuity growth method and the Gordon growth method.
The Gordon growth method has a unique terminal growth rate. Other terminal value calculations focus entirely on the firm’s revenue and ignore macroeconomic factors, but the Gordon growth method includes an entirely subjective terminal growth rate based on any criteria that the investor would like.
For example, the rate of cash flow growth might be tied to projected GDP growth or inflation. It could be arbitrarily set at 3%. This number is then added to earnings before interest, taxes, depreciation and amortization (EBITDA), then the resulting number is divided by the weighted average cost of capital (WACC) less the same terminal growth rate.
Most academic interpretations of terminal value suggest that stable (terminal) growth rates need to be less than or equal to the growth rate of the economy as a whole. This is one of the reasons why GDP is used as an approximate for the Gordon growth model.
Again, there is no conceptual reason to believe that this growth rate could be negative. A negative growth rate implies that the firm would liquidate part of itself each year until finally disappearing – making the choice to liquidate more attractive. The only instance when this seems feasible is when a company is being replaced slowly by new technology.
Firms Currently Earning Less Than the Cost of Capital
Declining or distressed firms are not easy for investors to valuate with terminal growth models. It is very possible that such a firm will never make it to steady growth. Nevertheless, it doesn’t make sense for investors to make that assumption whenever current costs of capital exceed current earnings.
A negative growth rate is particularly tricky with young, complex or cyclical businesses. Investors can’t reasonably rely on using existing costs of capital or reinvestment rates, so they might have to make risky assumptions about future prospects.
Whenever an investor comes across a firm with negative net earnings relative to cost of capital, it is probably best to rely on other fundamental tools outside of terminal valuation.