What is the terminal growth rate?
The terminal growth rate is a constant rate at which a firm’s expected free cash flowsFree Cash Flow (FCF)Free Cash Flow (FCF) measures a company’s ability to lớn produce what investors care most about: cash that"s available be distributed in a discretionary way are assumed khổng lồ grow, indefinitely. This growth rate is used beyond the forecast period in a discounted cash flow modelDCF Model Training Free GuideA DCF Mã Sản Phẩm is a specific type of financial model used khổng lồ value a business. The model is simply a forecast of a company’s unlevered không lấy phí cash flow, from the over of forecasting period until perpetuity, we will assume that the firm’s free cash flow will continue to grow at the terminal growth rate, rather than projecting the không lấy phí cash flow for every period in the future.
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A view of multi-stage growth rates
When making projections for a firm’s không tính tiền cash flowFree Cash Flow (FCF)Free Cash Flow (FCF) measures a company’s ability to lớn produce what investors care most about: cash that"s available be distributed in a discretionary way, it is common practice to assume there will be different growth rates depending on which stage of the business life cycle the firm currently operates in.
Typically, we construct a three-staged growth model lớn project a firm’s miễn phí cash flows and determine said firm’s value at each màn chơi of maturity:
#1 Expansion stage growth rateWe assume a high growth rate (usually over 10%) for business in its early stage of expansion. The business has established its position in the industry and is seeking khổng lồ increase its market nói qua. As such, it will experience rapid growth in revenueSales RevenueSales revenue is the income received by a company from its sales of goods or the provision of services.In accounting, the terms "sales" và and, thus, không tính tiền cash flow.
#2 Decelerated growth stageThe rapid-growth stage is often followed by a relatively decelerated growth stage, as the company will likely struggle to lớn maintain its high growth rate due to lớn the rising competition within the industry. The business will continue khổng lồ grow, but no longer at the substantial growth rate it had previously experienced.
However, as the company evolves closer khổng lồ maturity, it is expected to hold a steady market nội dung & revenue. We often assume a relatively lower growth rate for this stage, usually 5% to lớn 8%.
#3 Mature stage growth rateWe assume the company will grow at theterminal growth rate when it reaches a mature stage. At this stage, the company’s growth is minimal as more of the company’s resources are diverted lớn defending its existing market nội dung from emerging competitors within the industry.
A positive terminal growth rate implies that the company will grow into perpetuity, whereas a negative terminal growth rate implies the discontinuance of the company’s operations. The terminal growth rates typically range between the historical inflation rate (2%-3%) & the average GDPhường growth rate (3%-4%) at this stage.
A terminal growth rate higher than the average GDPhường growth rate indicates that the company expects its growth to lớn outperform that of the economy forever.
Application of the terminal growth rate
The terminal growth rate is widely used in calculating the terminal valueDCF Terminal Value FormulaDCF Terminal value formula is used lớn calculate the value a business beyond the forecast period in DCF analysis. It"s a major part of a model of a firm.
The “terminal value” of a firm is the net present valueNPV FormulaA guide khổng lồ the NPV formula in Excel when performing financial analysis. It"s important to understvà exactly how the NPV formula works in Excel và the math behind it. NPV = F / < (1 + r)^n > where, PV = Present Value, F = Future payment (cash flow), r = Discount rate, n = the number of periods in the future of its cash flows at points of time beyond the forecast period. The calculation of a firm’s terminal value is an essential step in a multi-staged discounted cash flow analysis & allows for the valuation of said firm.
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In a Discounted Cash Flow DCF ModelDCF Model Training Free GuideA DCF Mã Sản Phẩm is a specific type of financial mã sản phẩm used to value a business. The Model is simply a forecast of a company’s unlevered free cash flow,the terminal value usually makes up the largest component of value for a company (more than the forecast period).
The above sầu mã sản phẩm is a screenshot from CFI’s financial modeling courses.
Terminal growth rate formula
The perpetuity growth model for calculating the terminal value, which can be seen as a variation of the Gordon Growth ModelGordon Growth ModelThe Gordon Growth Model – also known as the Gordon Dividend Model or dividkết thúc discount Mã Sản Phẩm – is a stoông xã valuation method that calculates a stock’s intrinsic value, regardless of current market conditions. Investors can then compare companies against other industries using this simplified Model, is as follows:
Terminal Value = (FCF X <1 + g>) / (WACC – g)
Where:
FCF (miễn phí cash flow) = Forecasted cash flow of a company
g = Expected terminal growth rate of the company (measured as a percentage)
WACC = Weighted average cost of capitalWACCWACC is a firm’s Weighted Average Cost of Capital và represents its blended cost of capital including equity và debt.
We need to lớn keep in mind that the terminal value found through this model is the value of future cash flows at the over of the forecasting period. In order to calculate the present value of the firm, we must not forget khổng lồ discount this value to the present period. This step is critical & yet often neglected.
Learn more in our financial modeling courses.
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Limitations of the multi-stage growth rate model
Although the multi-stage growth rate Model is a powerful tool for discounted cash flow analysis, it is not without drawbacks. To start, it is often challenging khổng lồ define the boundaries between each maturity stage of the company.
A significant amount of judgment is required to determine if, & when, the company has progressed inlớn the next state. In practice, it is difficult lớn convert qualitative sầu characteristics inkhổng lồ specific time periods.
Moreover, this model assumes that high growth rates transkhung immediately into lớn low growth rates upon the firm entering the next maturity cấp độ. Realistically, however, the changes tend lớn happen gradually over time.
These concepts are outlined in more detail in our không lấy phí introduction to lớn corporate finance course.
More resources and learning
We hope this has been a helpful guide khổng lồ terminal growth rates và the terminal growth rate formula. At CFI our missionMission & ValuesCFI"s mission is khổng lồ help anyone become a world-class financial analyst. Learn more about Corporate Finance Institute"s mission, vision, values & culture is lớn help you advance your career. With that in mind we’ve sầu designed these additional resources lớn help you along your path:
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