Terminal Growth Rate
IntermediateThe terminal growth rate is the constant annual rate at which a company's cash flows are assumed to grow forever after the end of the detailed forecast period in a discounted cash flow valuation.
In a DCF, analysts forecast cash flows year by year for a limited period, often five to ten years. After that, they assume the business settles into steady, long-term growth. The terminal growth rate represents this growth and is used to calculate the terminal value.
Because no company can grow faster than the whole economy forever, the terminal growth rate is usually set at or below the expected long-term growth of the economy, often in the range of about 2% to 3% in many developed economies, reflecting long-term inflation and real growth.
The choice has a large effect on value. Suppose cash flow in the first year after the forecast period is 10 million and the discount rate is 9%. With a terminal growth rate of 2%, the terminal value is about 143 million. With 3%, it rises to about 167 million.
Because the terminal value often makes up a large share of the total valuation, analysts test how sensitive their results are to different terminal growth rates and compare them with values from other methods, such as exit multiples.
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