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Okay hello and welcome to our video here that is going to explain the intuition behind the Gordon growth method that is used in a discounted cash flow analysis to explain the terminal value calculation or to calculate terminal value now the reason why we're going through this is that it's very, very common to use this formula and a DCF analysis but a lot of people a lot of books a lot of professors actually skip over the real explanation behind it entirely and that leads to a ton of questions out of all the DCF related topics I've covered in taught over the years the formula for terminal value as calculated with the Gordon growth method or the perpetuity growth method the long term growth method whatever you want to call it has generated more questions than probably anything else out there it's interesting to cover because it's not immediately obvious why the formula works the way it does so we're going to break it down in this lesson and first in step 1 we're going to go over the formula and the intuition behind it and then in step 2 we're going to go over the mathematical proof for it, so I'll warn you in advance that there is going to be some algebra here there is going to be some math that we have to do but if you are more analytical, and you want a rigorous proof of how this works we're going to cover that in step 2 so let's start this way off with step number 1 right here first now the familiar formula for this for terminal value as calculated with the Gordon growth method is just the final year of free cash flow times 1 plus the free cash flow growth rate, and then you divide that whole term by the discount rate minus the free cash flow growth rate at the bottom now just to show you an example of how this comes up I'm going to jump into Excel and bring up a file that has this and makes use of this formula, so that's an example of how you use it in Excel and the obvious question here is what does this actually mean why do we subtract the free cash flow growth rate in the bottom why do we have that bottom term discount rate minus free cash flow growth rate and then what's going on with the top term why do we take the final year free cash flow in the period we're modeling and then multiply it by the growth rate what's the deal with that what's really going on there and the basic idea behind this is as follows how much can we afford to pay for companies cash flows indefinitely into the future if we want a certain yield on our investment and that yield of course is called the discount rate in this analysis so to explain the intuition behind this I'm going to go through two scenarios the first one the first one here we're going to have no growth so the free cash flows we get from the company are going to stay the same every single year, so we're going to skip the growth part now for now because it's easier to explain this when we start out with no growth and show you what the discount rate and the net present value in the formula means, and...
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