The terminal growth assumption is a key component of the discounted cash flow (DCF) valuation method and is used to estimate the growth rate of cash flows beyond the explicit forecast period. It represents the expected long-term growth rate of the company and is typically applied when projecting cash flows into perpetuity.
The terminal growth assumption is based on the premise that a company’s cash flows will continue to grow at a sustainable rate indefinitely. It is influenced by various factors, including industry growth rates, market conditions, competitive dynamics, and macroeconomic trends.
The terminal growth assumption should be reasonable, supported by a solid understanding of the company’s industry and market dynamics.
There are different approaches to determine the terminal growth rate:
✳ Historical Growth: Analyze the company’s historical growth rates and use them as a basis for estimating the future growth rate. This approach assumes that the company will continue to grow at a similar rate in the long term.
✳ Comparable Company Analysis: Look at the growth rates of similar companies in the industry to derive an appropriate terminal growth rate. This approach leverages market data to estimate the long-term growth prospects of the company.
✳ Macro-economic Analysis: Consider broader economic factors, such as GDP growth, inflation rates, and demographic trends, to determine the terminal growth rate. This approach takes into account the overall economic conditions and their impact on the company’s future growth potential.
It’s important to exercise caution when selecting the terminal growth rate as it can significantly impact the valuation outcome. Unrealistically high or low growth assumptions can lead to distorted valuations. It is recommended to use conservative and well-supported estimates based on a thorough analysis of the company’s industry, competitive landscape, and future prospects.
