Introduction

The terminal growth rate is a key component of the discounted cash flow (DCF) valuation model. It is the rate at which a company's free cash flow (FCF) is expected to grow in perpetuity beyond the explicit forecast period.

The terminal growth rate is typically estimated using a variety of methods, such as:

• Perpetuity growth rate method: This method assumes that the company's FCF will grow at a constant rate in perpetuity. The growth rate is typically estimated based on the company's long-term growth prospects and the growth rate of the overall economy.
• Exit multiple method: This method estimates the terminal growth rate based on the valuation multiples of similar companies that have been recently acquired or sold.
• Dividend growth rate method: This method estimates the terminal growth rate based on the company's historical dividend growth rate.

It is important to note that the terminal growth rate is a critical assumption in the DCF valuation model. A small change in the terminal growth rate can have a significant impact on the overall valuation of the company.

How to Use the Terminal Growth Rate in DCF

The terminal growth rate is used to calculate the terminal value of the company. The terminal value is the net present value of all future cash flows beyond the explicit forecast period. It is calculated as follows:

Terminal Value = FCF * (1 + g) / (WACC - g)

Where:

• FCF is the company's free cash flow in the last year of the explicit forecast period.
• g is the terminal growth rate.
• WACC is the company's weighted average cost of capital.

Once the terminal value has been calculated, it is discounted back to the present day using the WACC. This gives the present value of the terminal value, which is then added to the present value of the cash flows in the explicit forecast period to get the overall valuation of the company.

Example

Consider a company with the following financial data:

• Free cash flow in the last year of the explicit forecast period: $100 million
• Terminal growth rate: 3%
• Weighted average cost of capital: 10%

The terminal value of the company would be calculated as follows:

Terminal Value = $100 million * (1 + 3%) / (10% - 3%) = $1,233 million

The present value of the terminal value would be calculated as follows:

Present Value of Terminal Value = $1,233 million / (1 + 10%) = $1,121 million

The overall valuation of the company would then be calculated as follows:

Overall Valuation = Present Value of Terminal Value + Present Value of Cash Flows in Explicit Forecast Period

Conclusion

The terminal growth rate is a key component of the DCF valuation model. It is important to carefully consider the assumptions made when estimating the terminal growth rate, as they can have a significant impact on the overall valuation of the company.