Estimating terminal growth rates
The terminal value is a key component of any valuation. A significant portion of a company’s future cash flows will be generated beyond the Valuecruncher 3-year forecast period. The value of these cash flows is recognised in the terminal value calculation.
Valuecruncher uses a perpetuity (the company continues to generate cash flows forever) approach to calculate the terminal value that incorporates the discount rate, year 3 free cash flow and a terminal growth rate.
The terminal growth rate is an approximation that reflects the ongoing growth potential of the company’s cash flows. The company’s growth rate will fluctuate with economic and industry cycles with the terminal growth rate representing an average growth rate.
- Historic growth rates
- Forecast 3-year growth rates
- Terminal capital expenditure (e.g. how much is the company investing in R&D)
- Competitive advantages (e.g. long-term contracts, rights or patents)
- Current and potential market size
- Industry dynamics (e.g. competition and barriers to entry)
- Macroeconomic factors (e.g. GDP growth and inflation)
When determining the terminal growth rate it is important to ensure the assumption is consistent with the terminal capital expenditure estimate, e.g. How much capital expenditure is required to support Apple’s forecast 5.75% terminal growth rate?
The argument is often made that a company’s stable growth rate cannot exceed that of the economy. This constraint does not apply to the Valuecruncher terminal growth rate. The Valuecruncher terminal growth rate reflects a combination of the intermediate growth potential beyond year 3 and the company’s stable long-term growth rate.
The table below shows an implied terminal growth rate assuming the company’s year 3 growth rate converges to a stable growth rate by year 10.
Critics of the discounted cash flow methodology often cite the sensitivity of the valuation to subjective assumptions such as the the terminal growth rate as a weakness. Any methodology that recognises that valuation is a function of the company’s future cash flows should be sensitive to the company’s terminal growth rate. It is important to understand the growth implied by the valuation. Valuecruncher allows you to easily understand and quantify a valuation’s sensitivity to the company’s terminal growth rate.
If you have any questions on how to implement the Valuecruncher terminal growth rate don’t hesitate to contact us.