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Companies customarily report “depre-
ciation and amortization” as a single
line item in their income and cash flow
statements. However, valuators should
be attentive to the substantive differ-
ences between amortization and
depreciation, particularly with respect
to their impact on terminal value in
discounted cash flow calculations.
Amortization and depreciation
are both non-cash charges that reduce
reported income. Tax-deductible amor-
tization is similar to depreciation in
that it reduces both accounting income
and taxes, while non-tax-deductible
amortization reduces only accounting
income. However, there is an impor-
tant difference between amortization
and depreciation that must be recog-
nized by valuators when calculating
terminal value. Intangible assets have a
limited life and, importantly, differ
from fixed assets because specific
intangible assets are not systematically
replaced in the ordinary course of busi-
ness. Since amortization, unlike depre-
ciation, does not grow in perpetuity, it
should be separately valued in termi-
nal value calculations.
The most common way in which
intangible assets are created is through
acquisitions. In an asset acquisition,
the acquiror may write up acquired
assets to fair market value and depreci-
ate the tangible fixed assets based on
their written-up value. The difference
between the net value of the tangible
assets and the acquisition price is an
intangible asset. Under US GAAP, the
acquirer first allocates the value of the
intangible asset to such items as
patents, trademarks, customer lists
and contracts, and then books any
excess amount as goodwill. The values
of intangible assets derived from asset
acquisitions generally are amortized
for tax purposes on a straight line basis
over a 15-year life.1
In a non-taxable stock-for-stock
transaction, tangible assets may not be
written up for tax purposes, and amor-
tization of goodwill and other intangi-
ble assets is not tax-deductible. In tax-
able stock acquisitions, however, if a C
corporation acquires another C corpo-
ration from its shareholder, the
acquiror may make an election under
§338 of the Internal Revenue Code and,
under certain conditions, elect to create
an intangible asset by writing up the
assets in the same manner as in an
asset purchase.2
aMoRtization Must Be
excluDeD fRoM
noRMalizeD fcf in the
GoRDon GRoWth MoDel
The formula applied for calculating
terminal value in the Gordon Growth
Model is:
The formula is based on the assump-
tion that free cash flow (FCF) is expect-
ed to grow at a constant rate in perpe-
tuity. Free cash flow (F) in the Gordon
Growth Model equation is normalized
free cash flow in the terminal year.
Because amortization of intangibles
has a limited life, it must be excluded
from free cash flow when a growth
model is used to calculate terminal
value.3Amortization does not grow
with inflation, so it should be excluded
from the numerator in the formula. In
a company’s financial projections,
amortization should be a flat or declin-
ing number, unless the projection
specifically assumes future events,
such as acquisitions, that will enable
the company to create additional
intangible assets.
Even though amortization
should be excluded from the computa-
tion of terminal value, any tax benefit it
generates has value and should be
included in enterprise value. The
appropriate manner to value amortiza-
tion subsequent to the projection peri-
od is to separately determine the pres-
ent value of the future tax benefits of
the remaining amortization.
FCF must also be normalized to
exclude not only amortization of intan-
gible assets but also any other items
that will not be growing over time
and/or have a finite term, such as tax-
loss carryforwards, royalties receivable
or payable that have a limited life, non-
compete agreements, and payments to
former executives. The present value of
future cash flows after the projection
period from amortization, tax-loss car-
ryforwards, and other limited-life
items should be included in enterprise
value. The value of tax-loss carryfor-
wards after the projection period is the
present value of future tax benefits.
The value of future limited-life income
expert
TIP
Amortization must be excluded
from normalized FCF in the
Gordon Growth Model.
Continued on next page
GilBeRt e. MattheWs, cfa
Sutter Securities Incorporated
San Francisco, CA
gil@suttersf.com
This article is adapted from a forthcoming article in Business Valuation Review
entitled "Capital Expenditures, Depreciation and Amortization in the Gordon Growth
Model."
.
2.
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streams is present value of the after-tax
income net of taxes, and the value of
future limited-life obligations is pres-
ent value of the expense net of taxes.
These adjustments are achieved
by adding the present value of these
net cash flows after the terminal year
to enterprise value, as shown in the fol-
lowing equation:
eRRoneous tReatMent of
aMoRtization By the couRt
An example of the erroneous treatment
of amortization in a DCF analysis is the
2007 Dr Pepper Bottling decision. Annu-
al tax-deductible amortization of $5.4
million was included as a non-cash
charge in the court’s valuation model.4
Terminal value was determined by
applying a growth rate to the annual
free cash flow at the end of the projec-
tion period.5Since amortization was
part of the free cash flow that the testi-
fying experts used in their growth
models, they effectively assumed that
the amortization was perpetual, which
led to an overstated valuation by the
court. Since the decision did not dis-
cuss the amortization’s scheduled life,
it is not possible to quantify its impact
on the valuation. If we assume, for
example, the amortization had been
projected to continue for five years
beyond the projection period, the
court’s valuation would have been
reduced by more than 5 percent.6
conclusion
Amortization of intangible assets, loss
carryforwards, and other limited-life
assets should be excluded from the
normalized free cash flow on which
terminal value is calculated. Instead,
they should be separately valued.
Since data supplied by management
often lumps depreciation and amorti-
zation together, the valuator must
obtain the granular information neces-
sary for an appropriate analysis. c
The author thanks M. Mark Lee, CFA,
ASA, and Michelle Patterson, PhD, LLD,
for their helpful comments and assistance.
1The details of tax and accounting treatment of amortiza-
tion of intangible assets are beyond the scope of this
article.
2This election is not permitted unless the acquiror and
the seller mutually agree on the write-up prior to the
closing of the transaction.
3It also should be excluded from a multiple-based calcu-
lation of terminal value.
4Crescent/Mach I Partnership, L.P. v. Dr Pepper Bottling
Co. of Texas, 2007 Del. Ch. LEXIS 63 (May 2, 2007) at
*36. The opinion does not specifically state that the pro-
jected increases in depreciation and amortization
assumed flat amortization, but is seems reasonable to
assume that the annual increases were attributable to
depreciation.
5Id. at *53-*54.
6See Matthews, “Errors and Omissions in DCF Calcula-
tions: A Critique of Delaware’s Dr Pepper Appraisal,”
Business Valuation Update (October 2007), pp. 1, 10.
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