What Is Terminal Growth Rate?
The terminal growth rate is the constant rate at which a company's free cash flow is assumed to grow indefinitely beyond a specific forecast period in a Discounted Cash Flow (DCF) model. This rate is a critical input in financial modeling and Valuation, falling under the broader category of financial modeling. It is used to calculate the terminal value, which represents the present value of all cash flows beyond the explicit forecast horizon, often accounting for a significant portion of a company's total estimated value. The terminal growth rate reflects the long-term, stable Growth Rate a business is expected to achieve in perpetuity.
History and Origin
The concept of valuing assets based on perpetual cash flows can be traced back to early financial theories, notably in the context of dividend streams. One of the foundational models incorporating a constant growth rate into perpetuity is the Gordon Growth Model, developed by Myron J. Gordon and Eli Shapiro in the mid-20th century, building upon earlier work by John Burr Williams in the 1930s. This model, a form of the Dividend Discount Model, posits that the intrinsic value of a stock is the present value of its future dividends growing at a constant rate forever. As valuation methodologies evolved, particularly with the widespread adoption of discounted cash flow analysis, the principle of a terminal growth rate was applied to total company free cash flows to capture value beyond explicit projection periods.
Key Takeaways
- The terminal growth rate is a crucial assumption in discounted cash flow (DCF) models, representing the constant rate at which a company's cash flows are expected to grow indefinitely.
- It is used to calculate the terminal value, which often constitutes a substantial portion of a company's total valuation.
- The chosen rate should generally be conservative, typically not exceeding the long-term rate of Economic Growth or the expected rate of Inflation for a mature economy.
- Small changes in the terminal growth rate can lead to significant variations in the overall valuation.
- It reflects a company's sustainable long-term performance rather than short-term fluctuations.
Formula and Calculation
The terminal growth rate ($g$) is a variable within the Gordon Growth Model formula, which is commonly used to calculate the terminal value (TV) in a Discounted Cash Flow (DCF) analysis. The formula for terminal value using the perpetuity growth method is:
Where:
- (TV) = Terminal Value
- (FCF_{n+1}) = The Free Cash Flow in the first year beyond the explicit forecast period (Year n+1). This is typically calculated by taking the Free Cash Flow in the final explicit forecast year ((FCF_n)) and growing it by (1 + g).
- (WACC) = Weighted Average Cost of Capital, which serves as the Discount Rate used to bring future cash flows to their present value.
- (g) = The terminal growth rate, assumed to be constant in perpetuity.
This formula relies on the critical assumption that the discount rate (WACC) is greater than the terminal growth rate ((g)), otherwise, the denominator would be zero or negative, leading to an undefined or nonsensical terminal value.
Interpreting the Terminal Growth Rate
Interpreting the terminal growth rate requires careful consideration as it fundamentally represents the long-term sustainability and growth prospects of a business. A typical range for the terminal growth rate is between 0% and 3%, aligning with or slightly below the long-term rate of economic growth or inflation in developed economies. For instance, if a company were expected to grow faster than the overall economy indefinitely, it would eventually become larger than the entire economy, which is generally not a realistic assumption for a single entity. Therefore, the selection of this rate is a subjective yet crucial aspect of financial modeling.
A higher terminal growth rate implies greater future value, suggesting stronger long-term Profitability and market presence. Conversely, a lower rate indicates more modest or stagnant long-term prospects. Analysts often conduct sensitivity analyses to assess how different terminal growth rates impact the overall valuation, highlighting the inherent uncertainty in long-term projections. It is vital to justify the chosen rate based on industry outlook, competitive landscape, and macroeconomic factors.
Hypothetical Example
Consider a company, "InnovateTech Inc.," which is undergoing a discounted cash flow (DCF) valuation. Financial analysts have projected InnovateTech's Free Cash Flow for the next five years. In the fifth and final year of the explicit forecast period, the projected Free Cash Flow ((FCF_5)) is $100 million. The company's Weighted Average Cost of Capital (WACC) has been determined to be 9%.
To calculate the terminal value, a terminal growth rate must be assumed. The analysts believe that after five years, InnovateTech will have matured and will grow at a steady rate, roughly in line with long-term economic expansion. They decide on a terminal growth rate ((g)) of 2.5%.
First, calculate the Free Cash Flow for the first year of the terminal period ((FCF_{n+1})):
(FCF_{6}) = (FCF_5) * (1 + (g)) = $100 million * (1 + 0.025) = $102.5 million
Next, apply the terminal value formula:
(TV) = (FCF_{n+1}) / ((WACC) - (g))
(TV) = $102.5 million / (0.09 - 0.025)
(TV) = $102.5 million / 0.065
(TV) ≈ $1,576.92 million
This calculated terminal value of approximately $1.58 billion would then be discounted back to the present day using the WACC and added to the present value of the explicit forecast period cash flows to arrive at InnovateTech's total enterprise value. This example illustrates how the terminal growth rate anchors the valuation of distant future cash flows.
Practical Applications
The terminal growth rate is predominantly used in financial modeling, particularly within the Discounted Cash Flow (DCF) valuation framework. It allows analysts to account for a company's value beyond a typical 5-10 year explicit forecast period, recognizing that businesses are generally expected to continue operations indefinitely.
5Key practical applications include:
- Corporate Valuation: It is integral to determining the total enterprise value or equity value of a company, whether for mergers and acquisitions, initial public offerings (IPOs), or strategic planning. Financial analysts rely on it to project a company's long-term Free Cash Flow generation.
*4 Investment Analysis: Investors use DCF models incorporating terminal growth rates to assess the intrinsic value of a stock, helping them decide whether an asset is undervalued or overvalued. - Project Evaluation: While typically applied to entire companies, the concept can also be adapted for long-term projects with indefinite lifespans, where a Sustainable Growth Rate is assumed for cash flows beyond the initial projection.
- Financial Planning: Businesses may use the underlying principles to forecast long-term revenue and earnings growth, aiding in capital budgeting decisions, including Capital Expenditures and Working Capital management.
- Economic Forecasting: The selection of a terminal growth rate often aligns with broad macroeconomic projections. For instance, analysts might look to long-term projections of real Gross Domestic Product (GDP) from central banks, such as those provided by the Federal Reserve, as a reasonable proxy for this rate.
3## Limitations and Criticisms
Despite its widespread use, the terminal growth rate, and consequently the terminal value, is a significant source of sensitivity and debate in Discounted Cash Flow (DCF) models. One primary limitation is the inherent subjectivity and uncertainty involved in forecasting a perpetual growth rate. Predicting a company's performance decades into the future, let alone indefinitely, is challenging, and small adjustments to the terminal growth rate can lead to large swings in the calculated terminal value, which often constitutes 50% to 80% of the total valuation.
2Critics argue that:
- Sensitivity to Inputs: The model is highly sensitive to both the chosen terminal growth rate and the Weighted Average Cost of Capital. Even a slight misestimation of either can drastically alter the final valuation, leading to a wide range of possible outcomes.
*1 Unrealistic Perpetuity Assumption: Assuming a company can grow at a constant rate forever, especially if that rate is above the long-term Economic Growth rate, is often unrealistic. Such a scenario would imply that the company would eventually become larger than the entire economy. As a result, analysts typically cap the terminal growth rate at or below the nominal long-term GDP growth rate. - Lack of Flexibility: The model does not easily account for potential shifts in industry dynamics, competitive landscapes, technological disruptions, or changes in a company's business model beyond the explicit forecast period.
- "Garbage In, Garbage Out": As with many financial models, the reliability of the output (the valuation) is entirely dependent on the quality and realism of the inputs, particularly the terminal growth rate assumption. Imprudent or overly optimistic assumptions can render the valuation meaningless.
Terminal Growth Rate vs. Perpetual Growth Rate
The terms "terminal growth rate" and "Perpetual Growth Rate" are often used interchangeably in financial modeling, particularly in the context of Discounted Cash Flow (DCF) valuation. Both refer to the constant rate at which a company's cash flows are assumed to grow into perpetuity beyond an explicit forecast period.
However, a subtle distinction can be made in practice or academic discourse. "Perpetual growth rate" might sometimes be used more broadly to describe any constant growth assumed to continue forever, as seen in the Gordon Growth Model applied directly to dividends. "Terminal growth rate," on the other hand, more explicitly frames this perpetual growth within the context of the "terminal period" of a DCF model, which begins after a detailed, finite forecast of individual years. In essence, the terminal growth rate is the perpetual growth rate applied to the cash flows at the end of the explicit forecast period to calculate the terminal value. They are functionally identical in the calculation of terminal value within a standard DCF framework.
FAQs
What is a reasonable terminal growth rate to use?
A reasonable terminal growth rate is typically between 0% and 3%. It should not exceed the long-term nominal Economic Growth rate of the economy in which the company operates, nor should it generally exceed the long-term inflation rate for a mature business. For stable, mature companies, a rate closer to the expected long-term inflation rate (e.g., 2-2.5%) is often considered appropriate.
Why is the terminal growth rate so important in DCF?
The terminal growth rate is crucial because the terminal value, which it helps determine, often represents a significant portion—sometimes 50% to 80% or more—of a company's total estimated value in a Discounted Cash Flow (DCF) model. Even small changes in this rate can lead to substantial differences in the final Valuation, making it a highly sensitive assumption.
Can the terminal growth rate be negative?
While technically possible, a negative terminal growth rate is rarely used in practice for a going concern. A negative rate would imply that a company's cash flows will decline indefinitely, eventually reaching zero or negative values. This is inconsistent with the assumption of a stable, long-term business and usually indicates that the company is in a perpetual decline, for which alternative valuation methods might be more appropriate.
How do you determine the terminal growth rate for a company?
Determining the terminal growth rate involves judgment based on several factors: the long-term expected Economic Growth rate, the expected long-term Inflation rate, the company's industry maturity, competitive advantages, and the likelihood of its continued existence and modest growth into perpetuity. It should reflect a Sustainable Growth Rate that the company can maintain without requiring excessive Capital Expenditures.