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

What Is Adjusted Long-Term Growth Rate?

The Adjusted Long-Term Growth Rate is a critical assumption used in financial modeling, particularly within the realm of Valuation Models, to project a company's financial performance far into the future. It represents the sustainable rate at which a company's free cash flows or earnings are expected to grow indefinitely, after an initial period of potentially higher, but unsustainably rapid, expansion. This adjustment process aims to normalize the Growth Rate to a realistic, stable level that the business can maintain over the very long run, reflecting the broader economic environment rather than company-specific factors that might fade over time. The Adjusted Long-Term Growth Rate is a core input in calculating a business's intrinsic value.

History and Origin

The concept of using a long-term, stable growth rate in financial valuation gained prominence with the widespread adoption of Discounted Cash Flow (DCF) models, which require projections of future cash flows, often into perpetuity. Early valuation approaches sometimes applied a single, constant growth rate to all future periods, but it became clear that very high growth rates are rarely sustainable indefinitely. As financial theory evolved, particularly in academic and professional circles concerned with corporate finance and equity valuation, the need for a more realistic terminal growth assumption became apparent. Experts in valuation, such as Professor Aswath Damodaran, have extensively discussed the challenges and methods for estimating appropriate long-term growth rates, emphasizing that perpetual growth cannot exceed the nominal rate of Economic Growth for the economy in which the company operates.¹⁶ This pragmatic approach led to the refinement of how long-term growth is modeled, necessitating an "adjustment" from potentially higher near-term projections to a more conservative, achievable rate.

Key Takeaways

The Adjusted Long-Term Growth Rate is a crucial input for projecting future financial performance in valuation models, especially for determining Terminal Value.
It represents a sustainable, realistic rate of growth that a company can maintain indefinitely, typically not exceeding the nominal long-term economic growth or inflation.
This rate accounts for the eventual maturation of businesses, as very high growth rates are not perpetually sustainable.
The adjustment ensures that valuation models reflect a grounded future outlook, avoiding overestimation of intrinsic value.
Careful consideration of macroeconomic factors, such as Inflation and long-term GDP growth, is essential when determining this rate.

Formula and Calculation

The Adjusted Long-Term Growth Rate is not determined by a single universal formula but rather by a set of principles and considerations that guide its selection, particularly when used to calculate the Terminal Value in a Discounted Cash Flow (DCF) model. The core idea is that, in the long run, no company can grow faster than the overall economy indefinitely. Therefore, the long-term growth rate used in a terminal value calculation is typically capped.

For instance, in the Gordon Growth Model, often used to calculate terminal value, the formula is:

TV = \frac{FCF_{N+1}}{r - g}

Where:

(TV) = Terminal Value
(FCF_{N+1}) = Free Cash Flow in the first year beyond the explicit forecast period (Year N+1), which could be Free Cash Flow to Firm (FCFF) or Free Cash Flow to Equity (FCFE).
(r) = The discount rate, such as the Cost of Capital or Weighted Average Cost of Capital.
(g) = The Adjusted Long-Term Growth Rate (also known as the perpetual or terminal growth rate).

The selection of (g) is critical. It is generally set as:

Equal to or slightly below the long-term nominal growth rate of the economy: This reflects the sum of the long-term real economic growth rate and the expected long-term Inflation rate.
Less than or equal to the Risk-Free Rate: As the risk-free rate typically reflects the long-term expected growth of the economy (plus inflation), the perpetual growth rate should not exceed it.

The "adjustment" comes from scaling back initial, higher Growth Rate projections to this sustainable long-term rate. For example, a company might grow at 15% for the next five years, but its adjusted long-term growth rate for subsequent years might be set at 2.5% or 3%, aligning with the expected average long-term economic growth.

Interpreting the Adjusted Long-Term Growth Rate

Interpreting the Adjusted Long-Term Growth Rate involves understanding its implications for a company's future and its valuation. This rate is not a forecast of a company's actual performance in any single future year, but rather a representation of its average, sustainable growth over an indefinite period once it reaches a mature stage.

A properly adjusted long-term growth rate should align with macroeconomic realities. For instance, the International Monetary Fund (IMF) regularly publishes its World Economic Outlook, which includes projections for global and national Economic Growth and Inflation.¹⁵,¹⁴ Similarly, institutions like the Federal Reserve provide "longer-run" projections for key economic variables, including GDP growth.¹³,¹² These broader economic forecasts serve as benchmarks, as no single company can outgrow the entire economy indefinitely without eventually becoming the economy itself.

If the Adjusted Long-Term Growth Rate used in a Valuation Models is too high, it can significantly inflate the company's Terminal Value and, consequently, its overall valuation. Conversely, a rate that is too low might undervalue the company. Analysts must exercise judgment, ensuring that this rate reflects a realistic, steady state, considering factors like industry maturity, competitive landscape, and the limits of market expansion. The rate should generally be nominal, reflecting both real growth and anticipated Inflation.

Hypothetical Example

Consider a hypothetical technology startup, "InnovateTech Inc.", that has experienced rapid growth in its early years. For the first five years, financial analysts project InnovateTech's Free Cash Flow to Firm (FCFF) to grow at an aggressive 20% annually, reflecting its expanding market share and innovative products. However, after this initial high-growth phase, it is unrealistic to assume such a pace can continue indefinitely.

To perform a Discounted Cash Flow (DCF) valuation, analysts must estimate a sustainable Growth Rate for InnovateTech's cash flows into perpetuity. They assess the long-term nominal economic growth of the country where InnovateTech operates, which is estimated to be around 2.5% real growth plus 2% Inflation, totaling a 4.5% nominal growth rate.

Therefore, the analysts decide to use an Adjusted Long-Term Growth Rate of 4.0% for InnovateTech's cash flows beyond year five. This rate is slightly below the overall nominal economic growth to be conservative and reflects the eventual maturation of the company within a competitive market. This 4.0% rate will then be applied in the Terminal Value calculation, representing the point where InnovateTech's growth stabilizes and aligns with the broader economy.

Practical Applications

The Adjusted Long-Term Growth Rate is fundamentally applied in intrinsic Valuation Models, most notably the Discounted Cash Flow (DCF) model. Its primary practical applications include:

Equity Valuation: When valuing a public or private company, analysts use this rate to project cash flows into the perpetual period, which forms a significant portion of the total valuation. This ensures that the long-term prospects are aligned with economic realities, rather than extrapolating unrealistic short-term gains.
Mergers and Acquisitions (M&A): In M&A deals, the Adjusted Long-Term Growth Rate is crucial for determining the fair value of a target company. Acquirers use this rate to project the target's post-acquisition cash flows, informing their bidding strategy and ensuring the investment makes economic sense.
Capital Budgeting and Project Appraisal: Although typically applied to entire firms, the concept of a sustainable long-term growth rate can also influence the evaluation of very long-lived projects or investments within a company, ensuring that the expected returns are based on realistic, sustainable expansion.
Portfolio Management: Investment managers may consider the Adjusted Long-Term Growth Rate implied by market valuations of companies to assess if current stock prices are justified, or if they embed overly optimistic long-term expectations.
Economic Forecasting and Policy: While not a direct policy tool, the underlying principles that inform the Adjusted Long-Term Growth Rate – namely, the relationship between company growth and macroeconomic factors like GDP and Inflation – are derived from the same economic analyses used by institutions such as the Federal Reserve when considering Monetary Policy decisions and their longer-run projections.

Th¹¹e thoughtful selection of this rate prevents over-optimistic Growth Rate assumptions from skewing valuation outcomes, making it a cornerstone of sound financial analysis.

Limitations and Criticisms

While essential for pragmatic Valuation Models, the Adjusted Long-Term Growth Rate is not without its limitations and criticisms. A primary concern is its inherent subjectivity. The selection of this rate, though guided by principles like the long-term Economic Growth rate, still involves significant judgment from the analyst. Small variations in this assumed rate can lead to substantial differences in the calculated Terminal Value, which often accounts for a large percentage of a company's total intrinsic value in a Discounted Cash Flow (DCF) model.

Fu¹⁰rthermore, accurately predicting long-term macroeconomic factors like future Inflation and real GDP growth decades into the future is challenging. Unforeseen structural changes in industries, technological disruptions, or shifts in global economic power can render even well-researched long-term projections inaccurate. For example, a company might face entirely new competitive pressures or market dynamics far down the line, affecting its ability to sustain even a modest long-term Growth Rate. The model assumes a "steady state" where competitive advantages, investment opportunities, and profitability normalize, which may not always perfectly align with future realities. Additionally, the rate's sensitivity to the chosen Cost of Capital or Weighted Average Cost of Capital also presents a challenge, as slight changes in either input can significantly alter the valuation outcome.

##⁹ Adjusted Long-Term Growth Rate vs. Terminal Growth Rate

The terms "Adjusted Long-Term Growth Rate" and "Terminal Growth Rate" are often used interchangeably in financial modeling, particularly within Discounted Cash Flow (DCF) analysis. However, the "adjusted" descriptor emphasizes the process of normalizing the growth.

The Terminal Growth Rate refers to the constant Growth Rate assumed for a company's cash flows from a specified point in the future (the "terminal period") onwards, into perpetuity. It is used to calculate the Terminal Value of the company.

The Adjusted Long-Term Growth Rate is essentially the Terminal Growth Rate, but the "adjusted" highlights that this rate is carefully chosen or "adjusted" from initial, potentially higher, short-term growth forecasts to a sustainable, realistic level. This adjustment ensures that the long-term growth assumption does not exceed the nominal long-term Economic Growth rate of the economy in which the company operates. For example, while a company might experience 20% annual growth in its first few years, this cannot be sustained forever. The growth rate must be "adjusted" down to a more modest and stable figure, typically in line with macroeconomic Interest Rates and inflation, to reflect a mature business that cannot perpetually outgrow the overall economy. Thus, the Adjusted Long-Term Growth Rate explicitly acknowledges and incorporates this necessary normalization process.

FAQs

Why is an adjusted long-term growth rate necessary in valuation?

An adjusted long-term growth rate is necessary because no company can maintain exceptionally high growth indefinitely. Businesses eventually mature, and their growth rates tend to converge with the overall Economic Growth rate of the economy they operate in. Using an adjusted rate ensures that valuation models, like Discounted Cash Flow (DCF), provide a realistic and sustainable outlook for a company's future cash flows, preventing an overestimation of its intrinsic value.

What factors influence the selection of an adjusted long-term growth rate?

Key factors influencing the selection of an adjusted long-term growth rate include the expected long-term nominal Economic Growth rate (real GDP growth plus Inflation) of the country or region where the company primarily operates. Other considerations include the maturity of the industry, the company's competitive advantages, and the expected long-term Risk-Free Rate, as the growth rate should generally not exceed this.

Can the adjusted long-term growth rate be higher than the risk-free rate?

Generally, the adjusted long-term growth rate should not exceed the Risk-Free Rate. The risk-free rate often represents the long-term expected growth of the economy (including inflation), and it's considered unrealistic for a company to grow perpetually faster than the overall economy. Exceeding this benchmark in Valuation Models would imply that the company will eventually become larger than the entire economy, which is not feasible.

How does the adjusted long-term growth rate affect a company's valuation?

The Adjusted Long-Term Growth Rate significantly impacts a company's valuation by determining its Terminal Value, which often constitutes a substantial portion (sometimes 50% or more) of the total intrinsic value in a Discounted Cash Flow (DCF) analysis. A higher rate leads to a higher terminal value and thus a higher overall valuation, while a lower rate results in a lower valuation. This sensitivity underscores the importance of a carefully considered and realistic rate.

Is the adjusted long-term growth rate the same as the growth rate for Earnings Per Share (EPS)?

Not necessarily. While Earnings Per Share (EPS) growth is a measure of a company's historical or short-term performance, the Adjusted Long-Term Growth Rate refers to the sustainable growth of a company's free cash flows into perpetuity. High EPS growth might be achievable in the short term, but the adjusted long-term rate reflects a normalized, more conservative expectation that a company can maintain indefinitely, often tied to macroeconomic Economic Growth rather than specific EPS targets.¹ ² ³ ⁴ ⁵ ⁶ ⁷ ⁸