What Is Terminal Growth Rate in Financial Valuation?

The terminal growth rate is the estimated constant rate at which a company’s free cash flows are expected to grow indefinitely beyond a specific forecast period. This rate assumes that, after an initial period of more volatile growth, a company will settle into a sustainable and predictable growth pattern. It is a key component in assessing the long-term value of a business or asset within financial valuation models.

Role of Terminal Growth Rate in Financial Valuation

The terminal growth rate plays a significant role in financial valuation, particularly within discounted cash flow (DCF) analysis. Valuation models project a company’s cash flows for a finite explicit forecast period. Beyond this period, it becomes impractical to forecast individual cash flows year by year.

The terminal growth rate addresses this challenge by consolidating all future cash flows beyond the forecast horizon into a single value, known as the terminal value. This terminal value represents the present value of all cash flows expected to be generated by the company in perpetuity, assuming a stable, perpetual growth rate.

This perpetual growth assumption is a practical necessity in valuation, allowing analysts to account for a company’s ongoing operations and value creation beyond the detailed forecast period. The terminal growth rate captures the long-term, sustainable growth trajectory of the business. Without it, a significant portion of a company’s intrinsic value would be omitted from the valuation.

Methodology for Calculating Terminal Value

The terminal value, which incorporates the terminal growth rate, is commonly calculated using the Gordon Growth Model, also known as the Perpetuity Growth Model. This model estimates the value of cash flows expected to grow at a constant rate forever. The formula for terminal value is: Terminal Value = FCFn \ (1 + g) / (WACC – g).

In this formula, FCFn represents the free cash flow of the company in the last year of the explicit forecast period. The variable ‘g’ stands for the terminal growth rate, the constant rate at which these free cash flows are projected to grow indefinitely.

WACC, or the Weighted Average Cost of Capital, is the discount rate used to bring future cash flows back to their present value. It reflects the overall cost of financing a company’s assets, considering both debt and equity. An important condition for the Gordon Growth Model is that the terminal growth rate (‘g’) must be less than the Weighted Average Cost of Capital (WACC) to ensure a positive terminal value.

Influencing Factors for Terminal Growth Rate Selection

When determining an appropriate terminal growth rate, analysts consider various qualitative and quantitative factors to ensure the selected rate is sustainable and realistic. A common benchmark is the long-term growth rate of the overall economy, such as the historical gross domestic product (GDP) growth rate or the long-term inflation rate. Typical perpetuity growth rates often range between the historical inflation rate of 2-3% and the historical GDP growth rate of 4-5%.

No company can perpetually grow faster than the overall economy in the long run, as this would imply an ever-increasing share of the total economic output. Therefore, a terminal growth rate exceeding the average GDP growth rate of a country is considered unrealistic. Industry-specific growth prospects also play a role, but even within rapidly growing sectors, a company’s growth is expected to normalize over time.

Other considerations include the company’s competitive advantages, industry maturity, and its ability to continually reinvest and generate returns. A conservative approach is preferred, as even small changes in the terminal growth rate can significantly impact the overall valuation. In practice, terminal growth rates are frequently set within a range of 2.0% to 4.0%, with an average around 3.0%, reflecting a balance between economic growth and long-term sustainability.

Practical Application in Discounted Cash Flow Analysis

The calculated terminal value is a key component of a comprehensive discounted cash flow (DCF) analysis, integrating the long-term outlook into the overall valuation. Once determined using the Gordon Growth Model, it must be discounted back to its present value. This step uses the Weighted Average Cost of Capital (WACC) as the discount rate, similar to how explicit forecast period cash flows are discounted.

The present value of the terminal value represents the current worth of all cash flows generated by the company beyond the explicit forecast period. This component is then added to the present value of the free cash flows projected during the explicit forecast period. The sum of these two components yields the total intrinsic value of the company.

The terminal value often constitutes a significant portion of a company’s total estimated intrinsic value in a DCF model. This highlights its importance in valuation exercises. Therefore, the accurate calculation and appropriate discounting of the terminal value are important for arriving at an accurate estimate of a company’s worth.