FCFE with Inflation: How to Avoid Terminal Value Pitfall

When valuing firms through discounted cash flow, it is common to estimate the terminal value through the Gordon model. Some authors propose to adapt such model in the presence of inflation and for two particular cases: zero real growth and real growth through zero net present value projects. The discussion to the proposed adjustment (equal growth rate to inflation) is limited to the free cash flow to firm (FCFF) approach and is not unanimity. Our objective is to expand the discussion to the free cash flow to equity (FCFE) approach. Would the proposed adjustment also apply to the FCFE approach? We start corroborating the proposed adjustment for the FCFF approach, in our view. Then we reconcile the adapted model through a numerical example. After that we apply the same proposed adjustment to the FCFE approach. One would incur in error by following strictly the adjustments proposed for the FCFF approach: cash flow equals to income (changing net operating profit less adjusted taxes by earnings) and growth equals to inflation. We show that there is an additional necessary adjustment, either in the growth rate (dividing it by the weight of the equity in total capital) or in the earnings (proxy to the net cash flow). Both additional adjustments deliver the same outcome – which is also equal to the one the model adapted to the FCFF approach would deliver. We believe some practitioners might overlook such adjustments.