Perpetuity for Shareholder Value Method

The Perpetuity Method measures Residual Value by assuming that the firm provides a level stream of cash flows to its stakeholders forever. This assumption seems counter-intuitive. You expect that your firm continues to grow.

But, you can use a simple Perpetuity to compute Residual Value. Strategic Finance computes the perpetuity using a pre-investment cash flow stream. Because this stream doesn't include investment, the issue of future growth can be simplified by assuming that future investments earn exactly at the firm's Long-Term Cost of Capital rate—in other words, the Net Present Value of new investment after the forecast period is zero. (Another way to look at it is that the Internal Rate of Return on new investment equal the Long-Term Cost of Capital.)

Next it is necessary to determine which flows accrue to your firm in Perpetuity. Strategic Finance uses the after-tax value of Operating Profit, which includes Depreciation. (Depreciation represents the amount of investment needed to replace physical assets that wear out or become obsolete.) You can adjust this value if you believe that the last forecast period's Operating Profit is not representative of the on-going Operating Profit for the firm -- similar to the adjustment to Earnings in the P/E Ratio Method.

The formula for Perpetuity in Arrears (that is, when the payment occurs at the end of the period) is as follows:

(Operating Profit + Operating Profit Adj.) * (1 - RV Tax Rate) / Long-Term Cost of Capital

where:

Operating Profit

(v1150)

Taxable Operating Profit

Operating Profit Adj.

(v5110)

Normalized Operating Profit Adj.

RV Tax Rate

(v4.00.560)

Residual Value Tax Rate

L-T Cost of Capital

(v5005)

Long-Term Cost of Capital