Adjusted ending growth rate: Meaning, Criticisms & Real-World Uses

What Is Adjusted Ending Growth Rate?

The Adjusted Ending Growth Rate is a crucial assumption in financial modeling, particularly within a discounted cash flow (DCF) model, representing the sustainable, long-term growth rate of a company's cash flows beyond a detailed forecast period. This rate is "adjusted" to reflect realistic and achievable perpetual economic growth in a mature business, moving away from potentially high, unsustainable growth rates seen in earlier periods. As a concept within valuation, the Adjusted Ending Growth Rate plays a significant role in determining the terminal value of an asset or business, which often accounts for a substantial portion of the overall company value. It aims to prevent overestimation of future performance by aligning perpetual growth with broader economic indicators like long-term Gross Domestic Product (GDP) or inflation rates.

History and Origin

The concept of using a perpetual growth rate in valuation models gained prominence with the widespread adoption of the discounted cash flow (DCF) method in the mid to late 20th century. While specific historical figures for the "adjusted ending growth rate" are not documented as a distinct invention, its evolution is intertwined with the refinement of terminal value calculations. Early DCF models sometimes applied simplistic or overly optimistic perpetual growth rates, leading to inflated valuations. Financial analysts and academics, seeking to improve the accuracy and reliability of these models, recognized the necessity of a more conservative and economically justifiable long-term growth assumption. This led to the practice of "adjusting" the terminal growth rate to reflect sustainable, mature-phase growth, typically pegged to long-term macroeconomic trends rather than specific company-specific historical rates that are unlikely to persist indefinitely. This adjustment implicitly acknowledges that no company can perpetually grow faster than the overall economy.

Key Takeaways

The Adjusted Ending Growth Rate is a key input in calculating the terminal value in a DCF model.
It represents the sustainable, perpetual growth rate of a company's free cash flow beyond the explicit forecast period.
This rate is typically constrained by macroeconomic factors such as long-term GDP growth or inflation.
An unrealistic Adjusted Ending Growth Rate can significantly distort a company's overall present value and lead to inaccurate valuations.
It is a critical assumption requiring careful consideration and justification in financial modeling.

Formula and Calculation

The Adjusted Ending Growth Rate, often denoted as g in the perpetuity growth model for terminal value, is used in the following formula:

TV = \frac{FCF_{N} \times (1 + g)}{(WACC - g)}

Where:

(TV) = Terminal Value at the end of the explicit forecast period
(FCF_{N}) = Free Cash Flow in the last year of the explicit forecast period
(g) = Adjusted Ending Growth Rate (perpetual growth rate)
(WACC) = Weighted Average Cost of Capital (the discount rate)

It is crucial that the Adjusted Ending Growth Rate (g) is less than the Weighted Average Cost of Capital (WACC) to ensure a finite and logical terminal value. If g were equal to or greater than WACC, the denominator would be zero or negative, resulting in an infinite or nonsensical terminal value.

Interpreting the Adjusted Ending Growth Rate

Interpreting the Adjusted Ending Growth Rate involves understanding its implications for a company's long-term sustainability and market position. A positive, yet conservative, Adjusted Ending Growth Rate implies that the company is expected to continue generating free cash flows and grow at a steady pace into the future, but not at an unrealistic rate that would suggest it perpetually outpaces the broader economy or its industry. For instance, a common practice is to set the Adjusted Ending Growth Rate between the long-term inflation rate (typically 2-3%) and the average long-term GDP growth rate (historically around 3-4% for developed economies)¹⁵, ¹⁶.

An Adjusted Ending Growth Rate that is too high can lead to an inflated enterprise value and total valuation, making the company appear more valuable than it truly is¹³, ¹⁴. Conversely, a rate that is too low or negative might undervalue a healthy business, signaling an unwarranted expectation of decline. When performing investment analysis, analysts often perform sensitivity analysis on this growth rate to understand how different assumptions impact the final valuation.

Hypothetical Example

Consider a company, "Tech Innovations Inc.," for which an analyst is performing a DCF valuation. The explicit forecast period for Tech Innovations Inc. ends in Year 5. In Year 5, the projected free cash flow ((FCF_{5})) is $100 million. The company's Weighted Average Cost of Capital (WACC) has been calculated at 9%.

To determine the Terminal Value, the analyst needs to estimate the Adjusted Ending Growth Rate. Given Tech Innovations Inc. is a mature company in a developed economy, the analyst decides to use a conservative Adjusted Ending Growth Rate of 2.5%, which is slightly above the long-term expected inflation and below the long-term GDP growth.

Using the formula for Terminal Value:

TV = \frac{FCF_{5} \times (1 + g)}{(WACC - g)}

TV = \frac{\$100 \text{ million} \times (1 + 0.025)}{(0.09 - 0.025)}

TV = \frac{\$100 \text{ million} \times 1.025}{0.065}

TV = \frac{\$102.5 \text{ million}}{0.065}

TV \approx \$1,576.92 \text{ million}

This $1,576.92 million represents the company's value at the end of Year 5, based on the assumption that its free cash flows will grow perpetually at 2.5%. This Terminal Value then needs to be discounted back to the present value to be included in the total enterprise value.

Practical Applications

The Adjusted Ending Growth Rate is primarily applied in discounted cash flow (DCF) financial modeling for corporate valuation and investment analysis. It is particularly relevant for:

Mergers & Acquisitions (M&A): Analysts use it to value target companies, informing acquisition prices and deal structures.
Equity Research: Equity analysts incorporate this rate into their DCF models to arrive at price targets for publicly traded stocks.
Private Equity & Venture Capital: While early-stage companies often have very high initial growth rates, private equity firms valuing more mature portfolio companies will use an Adjusted Ending Growth Rate to project long-term cash flows.
Capital Budgeting: Companies may use DCF to evaluate long-term projects, where the Adjusted Ending Growth Rate helps assess the project's contribution beyond a specific forecast horizon.
Strategic Planning: Businesses use DCF models with Adjusted Ending Growth Rates to understand the long-term value implications of different strategic decisions.

The Congressional Budget Office (CBO), for example, provides long-term budget and economic outlooks, including projections for Gross Domestic Product and other economic indicators, which serve as benchmarks for realistic long-term growth assumptions in financial models¹².

Limitations and Criticisms

Despite its widespread use, the Adjusted Ending Growth Rate has several limitations and criticisms:

Sensitivity to Assumptions: The terminal value, heavily influenced by the Adjusted Ending Growth Rate, often constitutes a large percentage (sometimes over 75%) of a company's total valuation¹¹. Even small changes in this rate can lead to significant swings in the final valuation, making the model highly sensitive to this single assumption¹⁰.
Perpetual Growth Implication: The core assumption of perpetual growth, even at a modest rate, can be unrealistic for some industries or companies facing disruptive technologies or intense competition. No company is guaranteed to exist and grow indefinitely.
Difficulty in Forecasting: Accurately forecasting a truly "ending" or perpetual growth rate for decades into the future is inherently challenging and speculative. Macroeconomic factors like long-term economic growth and inflation can shift over time, impacting the appropriateness of a fixed rate⁸, ⁹.
"Steady State" Assumption: The model assumes the company eventually reaches a "steady state" where its capital expenditures equal depreciation and its working capital needs stabilize, allowing for a constant growth in free cash flow. This might not always be the case in dynamic markets.
Over-reliance on Macro Factors: While anchoring the rate to GDP or inflation provides a benchmark, it might oversimplify a specific company's unique long-term prospects, particularly if it operates in a niche or rapidly evolving sector.

One common mistake is using an overly optimistic Adjusted Ending Growth Rate that is higher than the country's expected long-term nominal Gross Domestic Product (GDP) growth, which implies the company will outgrow the entire economy forever – an unsustainable scenario. ⁵, ⁶, ⁷Another error is failing to adjust the cash flows in the terminal year to reflect a "normalized" state, making the perpetual growth assumption problematic.
⁴

Adjusted Ending Growth Rate vs. Terminal Growth Rate

The terms "Adjusted Ending Growth Rate" and "Terminal Growth Rate" are often used interchangeably in financial modeling and valuation. Both refer to the constant rate at which a company's free cash flow is assumed to grow indefinitely beyond the explicit forecast period in a discounted cash flow model. The "adjusted" in Adjusted Ending Growth Rate simply emphasizes the critical need to set this perpetual growth rate to a realistic, sustainable level, typically aligned with macroeconomic fundamentals like long-term GDP growth or inflation, rather than simply extrapolating historical company-specific growth which may be unsustainably high. It serves as a reminder that this final growth assumption must be prudent and justified.

FAQs

What is a reasonable Adjusted Ending Growth Rate?

A reasonable Adjusted Ending Growth Rate is typically a positive, low single-digit percentage that aligns with the long-term economic growth rate of the economy in which the company operates. This often falls between the historical inflation rate and the long-term Gross Domestic Product (GDP) growth rate, usually in the range of 2% to 4%.

Why is the Adjusted Ending Growth Rate so important in DCF?

The Adjusted Ending Growth Rate is crucial because it directly influences the terminal value of a company, which often represents the largest component of its total valuation in a discounted cash flow (DCF) model. A small change in this rate can lead to a significant difference in the final calculated present value of the business.

Can the Adjusted Ending Growth Rate be negative?

While typically positive, a negative Adjusted Ending Growth Rate implies that the company's cash flows are expected to decline perpetually. This might be considered for businesses in declining industries or those facing significant, insurmountable long-term challenges, but it's less common in standard valuation contexts for ongoing enterprises.

How do you choose the right Adjusted Ending Growth Rate?

Choosing the right Adjusted Ending Growth Rate involves judgment and relies on a thorough understanding of the company, its industry, and macroeconomic factors. Analysts consider long-term GDP growth expectations (e.g., from government bodies like the Congressional Budget Office (CBO)),³ historical inflation rates (available from sources like the Federal Reserve Bank of New York),² and the company's competitive advantages to arrive at a defensible rate. Historical global GDP data from sources like Our World in Data can also provide context.¹