The Terminal Growth Rate is the implied rate at which a company’s free cash flow (FCF) is expected to grow perpetually, after the initial forecast period of a two-stage DCF model.
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The terminal growth rate is the growth rate at which the free cash flows (FCFs) of a company are anticipated to continue growing after the initial projection period in a DCF model.
The standard DCF model can be split into two distinct stages:
Because the terminal value can comprise around three-quarters of a company’s total estimated intrinsic value, the terminal growth rate assumption is a key variable to sensitize to ensure the model output is reasonable.
In practice, the terminal growth rate is most often set between the range of 2.0% to 4.0% (and ~3.0% on average).
Companies that achieve growth and scale will encounter more challenges later on to maintain their historical pace of growth.
On that note, high growth rates are attainable for the long term, but reaching the “stable state” is an inevitable outcome for all companies.
The implicit assumption of the terminal growth rate is that the company’s free cash flow (FCF) will increase by the chosen rate perpetually.
Therefore, a terminal growth rate that exceeds the average gross domestic product (GDP) of a country is unreasonable, since that implies the company will continue to outpace the global economy indefinitely.
That sort of assumption is not only unrealistic but places the overall credibility of the DCF analysis into question.
The two common methods to estimate the terminal value (TV) are the exit multiple method and the perpetuity growth method.
The exit multiple method applies a valuation multiple derived from trading data on comparable peers operating in the same (or an adjacent) industry by a relevant operating metric.
Terminal Value (TV) = Valuation Multiple × Operating MetricSince the unlevered DCF values the projected free cash flow to firm (FCFF) available to all capital providers, including debt lenders and equity shareholders, enterprise value multiples must be used here, rather than equity value multiples.
On the other hand, the perpetuity growth method is a simpler approach, where the long-term growth rate assumption used is based on historical data and market data (inflation, GDP).
For that reason, the exit multiple method is often viewed more favorably, especially from an academic perspective, because the specific underlying assumptions can be more specifically justified.
Terminal Value (TV) = Free Cash Flow (FCF) in Terminal Year × (1 + g) ÷ (WACC – g)Note: The terminal growth rate assumption (g) must not exceed the weighted average cost of capital (WACC).
If the exit multiple approach was used to calculate the terminal value (TV), it is important to cross-check the amount by calculating an implied growth rate to confirm its reasonableness.
The formula to calculate the implied terminal growth rate is as follows.
Implied Terminal Growth Rate = [Discount Rate – (Final Year Free Cash Flow ÷ Terminal Value)] ÷ [1 + (Final Year Free Cash Flow ÷ Terminal Value)]
Unless there are atypical circumstances such as strict time constraints or the absence of financial data (“spotty data”), it is common practice to present the implied growth rate and implied valuation multiple side-by-side to serve as a “sanity check” on each other.
In theory, the terminal value under either approach – the exit multiple method and perpetuity growth method – should be reasonably close.
But if the percent variance is substantial, the assumptions underpinning the terminal value estimation most likely require adjusting.
We’ll now move to a modeling exercise, which you can access by filling out the form below.
Suppose we’re building a DCF model on a company given the following free cash flow to firm (FCFF) data.
Initial Forecast Period – Free Cash Flow to Firm (FCFF)
The weighted average cost of capital (WACC) – the discount rate we’ll use to calculate the present value (PV) of each cash flow – is 8.0%.
The mid-year convention will also be used here, which assumes that the cash flow is received in the middle of each period, rather than at year-end.
The sum of the Stage 1 FCFs is $285 million and we’ll assume the terminal growth rate is 2.5% as an explicit assumption.
In the next section, we’ll estimate the terminal value (TV), starting with growing the final year free cash flow (FCF) in Year 5 by (1 + g).
The terminal value at the end of the initial forecast period equals $76 million divided by the difference between 8.0% and the terminal growth rate of 2.5%.
Since the total enterprise value (TEV) derived from the DCF model is the company’s valuation as of the present date, we must discount the terminal value in Year 5 to determine the present value (PV) of the terminal value as $939 million.
The sum of the two present values (PV) of Stage 1 free cash flows (FCFs) and terminal value (TV) equals the implied enterprise value of $1.22 billion.
In conclusion, we’ll solve for the implied terminal growth rate by plugging our inputs into the formula from earlier, which comes out to 2.5%.
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