What is the perpetual annuity?
Because it is not possible to plan each fiscal year individually in the more distant future, the first three to five years are planned realistically in detail and a so-called “perpetual annuity” is applied as a lump sum for the period thereafter, which is derived conclusively from the planning. This perpetuity must be discounted because it is paid out at times that lie in the future.
The income value results from the addition of the discounted planned income and the discounted perpetuity.
Formulas for calculating the perpetual annuity
The perpetuity is equal to the long-term expected return divided by the long-term expected interest rate. If a rising risk-free base interest rate is assumed, this base interest rate must be included in the interest rate used to discount the perpetual annuity. If a higher market and/or company risk is assumed, these risks must be reflected in the risk-adequate interest rate.
Example: A company is expected to generate long-term income of EUR 100 thousand per year. If it is assumed that the base interest rate will be at a level of 5% and that the market risk will be reflected with a discount of 4% and that the company risk will correspond to 1.5 times the market risk, then the interest rate for discounting the perpetuity is 5% + 4% + 6% = 15%.
In this case, the perpetual annuity today is worth EUR 100 thousand/0.15 x (1+0.15)^-6 = EUR 667 thousand x 0.43 = EUR 288 thousand.
This is the role of the perpetual annuity for the company valuation
The perpetual annuity has a significant influence on the company value. The greater the confidence in the long-term, sustainable profitability of a company, the higher the perpetual annuity as a key component of the capitalized earnings value.
In turn, the capitalized earnings value is a key factor in calculating the value of a company. It is therefore worthwhile to position companies in a demonstrably resilient manner.