Estimating Terminal Values with Inflation: The Inputs Matter – It Is Not a Formulaic Exercise

Abstract

Estimation of the terminal value is a critical aspect of any corporate valuation. In a path breaking paper, Bradley and Jarrell showed that traditional methods for estimating the terminal value typically failed to deal properly with inflation. The premise underlying the Bradley-Jarrell analysis, namely that inflation applies to a firm’s capital stock in the same manner that it applies to other financial metrics, is straightforward. Unfortunately, the Bradley-Jarrell analysis is often misunderstood because of accounting issues that arise in its application and its apparent deviation from traditional formulas for plowback and growth. This paper addresses those details. In doing so, we demonstrate how to handle the issues that arise when applying the Bradley-Jarrell model to GAAP based financial statements or forecasts and we show how the Bradley-Jarrell approach can be reconciled with the traditional models.

Keywords: DCF Valuation, Terminal Value

JEL Classification: G1