The following article provides brief and concise information on the relationship between investments and depreciation in perpetual retirement.

Using the perpetual pension method (discounted cash flow), the value of the company after the end of a specific forecast period is estimated for an indefinite period of time in order to determine its present value. (The company's forecasted cash flows are also discounted over a specific forecast period in the calculation.) In the income value process, the perpetual pension is used to estimate the terminal value (terminal value) when the company's exact cash flows for the infinite future are difficult to predict. As a continuation value, the terminal value therefore describes the value contribution of the period following the defined forecast period.

Cash flow (DCF method) or income (income value method) in perpetual pension is considered an extremely value-sensitive parameter in the context of company valuation. In a 5-year detailed planning phase followed by a rough planning phase, terminal value often accounts for more than 75% of the company value. When evaluating SMEs with often shorter planning periods of just 3 years or with very ambitious growth plans, this figure is often even above the 85% mark.

### Three parameters determine the value contribution of the perpetual pension

Calculating the perpetual pension for the company valuation is a simple matter from a purely mathematical point of view; the valuer requires a “sustainable” cash flow or income, a growth rate and an appropriate discount interest rate for the value contribution.

It is less trivial than pure calculation to define the previously mentioned three parameters as shown below. There is no explicit distinction between DCF and income value methods, as both methods are based on the correct definition of the same influencing factors.

### Formula for the value of the perpetual pension — Determining the “sustainable” cash flow or income

In the DCF method, cash flow corresponds to the free cash flow of the last forecasted year; in the income value method, the forecast income for the last year of the planning period.

#### Inflation is a component of growth rate and capitalization interest rate

The two variables growth rate and capitalization interest rate are initially not directly related to each other. On closer inspection, however, it becomes clear that both the discount interest rate and the growth rate have a common component, the general rate of price increase. According to accepted theory and practice, a discount interest rate consists of the following components:

- Risk-free real return
- Premium for the expected rate of price increase
- Premium for business risk (equity) or credit default risk (debt capital)
- Premium for lack of liquidity

The growth rate of perpetual pension also consists of several components:

- Growth in sales volume, i.e. expansion of business through additional customers, etc.
- Price increase potential in the sales market
- Reducing the quantity of purchasing and production volumes
- Price increase in the shopping market

Volume growth rarely plays a dominant role among established companies. For young, fast-growing companies, business expansion over a longer period of time is conceivable, but certainly not to infinity. Increases in production efficiency are also limited, at least in the long term.

The growth rate is therefore always largely influenced by price increases on the earnings side and price increases on the cost side. In the long term, however, under the “going concern” premise, both cannot differ significantly from the general rate of price increase in the national economy, i.e. the inflation rate.

Read more about this topic here: **Sustained growth rate**

#### What to do in a low interest rate environment?

It becomes problematic when the evaluation implicitly includes two different assumptions about long-term price increases. In a low interest rate environment, even experienced company valuers can make these mistakes faster than expected.

On April 30, 2019, the figure for the 30-year risk-free federal interest rate — determined using the Svensson method and **published on the Bundesbank's website** — with a figure of 0.78% p.a., which share is attributable to real interest rates and which to inflation expectations is indicative. Negative real returns are certainly conceivable, and a liquidity premium in bond trading can also be assumed. Nevertheless, there is much to suggest that the current inflation expectation is not in line with the ECB's inflation target of 2.0%. In this respect, when setting the long-term growth rate, the company valuer should not overly generously calculate the component that is attributable to the price increase.

#### Cost of capital, growth discount and present value factor according to Gordon Growth

When it comes to present value, the correct estimate of the cost of capital plays a decisive role, as they are used as a discount rate. Various factors such as the company's risk and market interest rates are considered. With the **SmartZebra Capital Cost Module** capital costs can be determined quickly and easily in accordance with current standards.

Since companies are generally unable to grow at a certain growth rate for all eternity, the calculation also includes a growth discount and is a measure of how much of the expected growth rate of the perpetual pension is regarded as “risky” by investors. It is typically determined by a growth model based on historical data and future forecasts. A common model is the Gordon Growth Model, which calculates the growth discount as the difference between the expected growth rate of the perpetual pension and the discount rate. The present value factor, which is also known as excess return, can be seen inversely. The present value factor is used to calculate the present value of the perpetual pension by multiplying it by the expected annual cash flow. This results in the annual present value, which is then discounted to a current present value.