How to Find a Company’s Terminal Growth Rate

The terminal growth rate is an assumption in financial modeling, particularly within discounted cash flow (DCF) analysis. It represents the perpetual rate at which a company’s free cash flows are expected to grow indefinitely beyond a specific forecast period. This assumption determines a substantial portion of a company’s estimated long-term value, as it is a key component for calculating the terminal value.

Understanding Terminal Growth Rate

The terminal growth rate represents the assumed constant pace at which a company’s cash flows are expected to grow into perpetuity, following an initial explicit forecast period. This rate reflects the steady, sustainable growth a company is projected to achieve once it reaches a mature stage.

After its initial rapid growth, a business settles into a more stable growth pattern. The terminal growth rate must be a realistic, conservative estimate. A positive rate implies continued operations and expansion, while a negative rate suggests decline. This rate is typically lower than growth experienced during the explicit forecast period, reflecting a mature business environment.

Key Inputs for Terminal Value Calculation

Calculating terminal value requires specific financial inputs to project a company’s future value beyond the detailed forecast period.

One input is the discount rate, often represented by the Weighted Average Cost of Capital (WACC). This rate converts future cash flows into their present-day equivalent, reflecting the time value of money and risk. It represents the minimum acceptable rate of return an investor expects from an investment.

Another input is the cash flow in the terminal year, which is the last projected cash flow from the explicit forecast period. This cash flow acts as the starting point for applying the perpetual growth assumption and must be carefully determined for a reliable calculation.

Approaches to Estimating Terminal Growth Rate

Estimating a reasonable terminal growth rate requires considering various benchmarks and qualitative factors. One approach involves a company’s historical growth rate, though rapid past growth may not be sustainable indefinitely as it matures.

Another common benchmark is the long-term inflation rate. Companies generally cannot grow their real cash flows faster than the overall economy in perpetuity. The long-term inflation rate, often 2% to 3%, can serve as a conservative estimate for a mature company’s perpetual growth.

The long-term Gross Domestic Product (GDP) growth rate is also used as a ceiling. A company’s perpetual growth rate cannot realistically exceed overall economic growth, as this would imply the company eventually becoming larger than the entire economy. Average GDP growth rates, typically 3% to 4%, provide a macroeconomic context for sustainable long-term growth. Many practitioners often default to a terminal growth rate around 3%.

Calculating Terminal Value

Once the terminal growth rate and necessary inputs are identified, terminal value can be calculated using the Gordon Growth Model. This model determines the value of a company’s cash flows beyond the explicit forecast period. The formula is: Terminal Value = [Cash Flow (Year N+1) (1 + Terminal Growth Rate)] / (Discount Rate – Terminal Growth Rate).

“Cash Flow (Year N+1)” represents the projected cash flow in the first year beyond the explicit forecast period. This value is derived by taking the cash flow from the last year of the explicit forecast (Year N) and growing it by the terminal growth rate. For example, if cash flow in Year N was $100 million and the terminal growth rate is 2.5%, Cash Flow (Year N+1) would be $102.5 million.

The “Terminal Growth Rate” (g) is the constant, perpetual growth rate estimated for the company’s cash flows. The “Discount Rate” (WACC) is the weighted average cost of capital, representing the rate used to discount future cash flows to their present value. For instance, if Cash Flow (Year N+1) is $102.5 million, the Terminal Growth Rate is 2.5%, and the Discount Rate (WACC) is 8.0%, the Terminal Value would be approximately $1.86 billion. This calculated terminal value then needs to be discounted back to the present day for total valuation.

Factors Influencing Rate Selection

Selecting a specific terminal growth rate requires careful judgment, incorporating quantitative data and qualitative insights. The industry significantly influences the appropriate rate. Mature industries with limited growth prospects typically warrant a lower terminal growth rate, possibly closer to the inflation rate, than nascent industries. However, even high-growth industries eventually mature, and their perpetual growth rate should align with broader economic limits.

A company’s specific competitive advantages also play a role. Businesses with strong, sustainable advantages, such as a dominant market position or proprietary technology, might maintain a slightly higher perpetual growth rate. This advantage must be truly sustainable and difficult for competitors to replicate.

The overall economic outlook also influences the selection. In periods of expected lower economic growth or higher inflation, a more conservative terminal growth rate is prudent. Financial professionals prioritize conservatism when choosing this rate.