Perpetuity growth rate

What Is Perpetuity Growth Rate?

The perpetuity growth rate is a constant rate at which a company's free cash flow or dividends are assumed to grow indefinitely. It is a fundamental input in financial valuation models, particularly within the realm of financial valuation to estimate the value of a business beyond a specified forecast period. This rate is a key component of the terminal value calculation, representing the long-term, stable growth an entity is expected to achieve. The perpetuity growth rate is applied when a company is assumed to operate perpetually, generating cash flows that increase at a steady, predictable pace into the foreseeable future.

History and Origin

The concept of valuing an asset based on a perpetual stream of future income, often growing at a constant rate, has roots in economic thought and was formalized in financial theory. One of the most influential frameworks that popularized the use of a perpetual growth assumption is the Dividend Discount Model (DDM), specifically the Gordon Growth Model. This model, developed by Myron J. Gordon in his 1959 paper, "Dividends, Earnings, and Stock Prices," posits that a stock's intrinsic value can be calculated as the present value of its future dividends, assuming those dividends grow at a constant rate forever.¹¹, ¹², ¹³, ¹⁴, ¹⁵ This provided a structured approach to incorporate a perpetuity growth rate into valuation for equity.

Key Takeaways

• The perpetuity growth rate represents the assumed constant growth rate of cash flows or dividends into perpetuity.
• It is a crucial input for calculating the terminal value in discounted cash flow (DCF) models.
• The rate should realistically be less than or equal to the long-term nominal Gross Domestic Product (GDP) growth rate of the economy in which the company operates.
• Small changes in the perpetuity growth rate can significantly impact the calculated terminal value and overall business valuation.
• Selecting an appropriate perpetuity growth rate requires careful consideration of economic conditions, industry outlook, and company-specific factors.

Formula and Calculation

The perpetuity growth rate is used in the Gordon Growth Model component of the terminal value calculation within a discounted cash flow (DCF) model. The formula for the terminal value, incorporating the perpetuity growth rate, is:

Where:

• (TV) = Terminal Value
• (FCFF_{N+1}) = Free Cash Flow to Firm in the first year beyond the explicit forecasting period (N+1)
• (WACC) = Weighted Average Cost of Capital (the discount rate used to discount future cash flows)
• (g) = Perpetuity growth rate

This formula essentially treats the cash flows beyond the explicit forecast period as a growing perpetuity.

Interpreting the Perpetuity Growth Rate

Interpreting the perpetuity growth rate involves understanding its implications for a company's long-term prospects. This rate should not exceed the expected long-term nominal growth rate of the broader economy, as no single company can realistically grow faster than the overall economy forever. Factors like inflation and real economic growth contribute to the nominal growth rate.

A higher perpetuity growth rate implies a more optimistic outlook for the company's sustained profitability and expansion, leading to a higher calculated terminal value. Conversely, a lower rate or a zero growth rate suggests limited long-term potential, resulting in a lower valuation. It is critical to select a rate that is defensible given the company's industry maturity, competitive landscape, and overall economic growth expectations to produce a credible valuation.

Hypothetical Example

Consider a hypothetical company, "GreenTech Solutions," for which an analyst is performing a discounted cash flow (DCF) valuation. After an initial five-year explicit forecasting period, GreenTech's free cash flow to firm (FCFF) is projected to be $100 million in year 6 ((FCFF_{N+1})). The analyst determines GreenTech's Weighted Average Cost of Capital (WACC) to be 9%.

The analyst assumes a perpetuity growth rate of 2.5% ((g)) for GreenTech Solutions, reflecting a conservative long-term growth expectation in line with projected economic growth and the mature nature of GreenTech's primary market.

Using the terminal value formula:

This $1,538.46 million represents the present value of all cash flows beyond year 5, as of the end of year 5, assuming a 2.5% perpetuity growth rate. This terminal value is then discounted back to the present day along with the explicit forecast period cash flows to arrive at GreenTech's total enterprise value.

Practical Applications

The perpetuity growth rate is widely used in various financial contexts, primarily in valuation and investment analysis.

• Equity Research and Investment Banking: Analysts regularly employ the perpetuity growth rate in discounted cash flow (DCF) models to arrive at a company's terminal value, which often accounts for a significant portion of the total estimated value. This is crucial for advising on mergers and acquisitions, initial public offerings (IPOs), and capital-raising activities. Companies like those found in the SEC's EDGAR database, when outlining their long-term prospects, implicitly or explicitly consider assumptions akin to a perpetuity growth rate in their internal models.⁹, ¹⁰
• Corporate Finance: Businesses use the perpetuity growth rate internally for strategic planning, evaluating major investment projects (e.g., capital expenditures), and assessing the long-term impact of operational changes on future cash flow.
• Portfolio Management: Fund managers and institutional investors utilize DCF analysis with perpetuity growth rates to make informed decisions about buying, selling, or holding securities, assessing whether a stock is undervalued or overvalued based on its intrinsic worth.
• Economic Forecasting: While not a direct forecast, the choice of a perpetuity growth rate often aligns with broader macroeconomic projections. For instance, global growth rates published by organizations like the International Monetary Fund (IMF) in their World Economic Outlook reports provide a reasonable upper bound for long-term growth assumptions in valuation models.⁴, ⁵, ⁶, ⁷, ⁸ As of late July 2025, the IMF projects global growth rates of 3.0% for 2025 and 3.1% for 2026.³

Limitations and Criticisms

Despite its widespread use, the perpetuity growth rate faces several limitations and criticisms:

• Sensitivity to Assumptions: The terminal value and, consequently, the overall valuation are highly sensitive to small changes in the perpetuity growth rate. A slight increase or decrease in this rate can lead to a substantial difference in the final valuation figure. Aswath Damodaran, a prominent finance professor, highlights this sensitivity, noting that the terminal value can often represent a large percentage of a company's total estimated value, making the underlying assumptions, including the perpetuity growth rate, critically important.¹, ²
• Unrealistic Perpetuity: Assuming that a company can grow at a constant rate forever is a simplification. Real-world companies rarely maintain consistent growth indefinitely due to evolving competitive landscapes, technological disruptions, market saturation, and changes in reinvestment rates or working capital needs.
• Difficulty in Estimation: Determining an appropriate perpetuity growth rate is challenging. It must be a sustainable rate, generally not exceeding the nominal long-term growth rate of the economy. However, predicting long-term economic growth is inherently difficult and subject to considerable risk.
• The "Plug" Problem: Sometimes, analysts may back into a perpetuity growth rate that yields a desired valuation, rather than deriving it from a rigorous, justifiable economic basis. This can undermine the credibility of the model.

Perpetuity Growth Rate vs. Terminal Value

The perpetuity growth rate and terminal value are closely related but distinct concepts in financial valuation.

The perpetuity growth rate is the assumption about the constant rate at which a company's cash flow or dividends will grow indefinitely after the explicit forecasting period. It is a specific input, typically a single percentage.

The terminal value, on the other hand, is the calculated value of all a company's future cash flows beyond the explicit forecast period, discounted back to the end of that forecast period. It is a large lump sum that represents the continuing value of the business as a going concern. The perpetuity growth rate is one of the key variables used to compute the terminal value. Without a specified perpetuity growth rate (or another method like an exit multiple), calculating a terminal value in a discounted cash flow model would not be possible for companies assumed to have an infinite life.

FAQs

What is a reasonable perpetuity growth rate?

A reasonable perpetuity growth rate is typically between 0% and the long-term nominal Gross Domestic Product (GDP) growth rate of the economy in which the company operates. It should generally not exceed the expected rate of inflation plus the long-term real GDP growth. For mature economies, this often falls in the range of 1% to 3%.

Why is the perpetuity growth rate important in valuation?

The perpetuity growth rate is critical because it directly influences the terminal value, which often accounts for a substantial portion (50% to 80% or more) of a company's total estimated value in a discounted cash flow (DCF) model. Even small changes to this rate can significantly impact the final valuation.

Can the perpetuity growth rate be negative?

While technically possible, a negative perpetuity growth rate is rarely used in practice for going concern valuations. A negative rate implies that a company's cash flows will decline indefinitely, suggesting that the business is in a perpetual state of contraction or eventually liquidating. Such a scenario might be modeled more appropriately using a finite life or a liquidation valuation approach rather than a perpetuity model.

How does the perpetuity growth rate relate to the sustainable growth rate?

The sustainable growth rate is a measure of how quickly a company can grow without external financing, based on its profitability and reinvestment rate. While the sustainable growth rate describes a company's internal capacity for growth, the perpetuity growth rate is an assumption about its actual long-term, stable growth, which should ultimately converge to the broader economic growth rate as the company matures. The sustainable growth rate can inform the early stages of a forecasting period, but the perpetuity growth rate reflects a stable state where the company no longer grows significantly faster than the economy.