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.
Key terminal growth considerations
- 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.
Tags: terminal growth, valuation
July 29th, 2008 at 4:10 am
I am doing some DCF assignment right now, had a question regarding terminal growth rate, it this rate only apply for cap rates or i should apply TGR at the last year of 10 years DCF analysis, for example, the the anual growth is 12%, and terminal growth rate is 5%, is that means i should apply 5% to the last year grow of year 10, or i should apply 12% at year 10?
Thanks.
July 31st, 2008 at 10:04 am
Hi Rick,
Valuecruncher uses a perpetuity approach based on the following formula: PV(t) = FCF(t)(1+TGR)/(WACC - TGR). Applying this model to a 10 year framework results in PV(10) = FCF(10) (1 + 5%)/(WACC - 5%) where FCF(10) = FCF(9) (1 + 12%). If I was using a cap rate beyond year 10 such as a 2 times FCF multiple (arbitrary example) I would use 2 x FCF(11) where FCF(11) = FCF(10)(1 + 5%) (just take care to use the year 11 discount rate here).
Hopefully this response is not too algebraic. The Damodaran’s site (http://pages.stern.nyu.edu/~adamodar/ ) is an excellent resource not only does it have pdf versions of his text books available it also has a number of excel worksheets.
Sam
August 25th, 2008 at 4:30 am
Very interesting. I’ll surf you blog. Will it be continued?
December 12th, 2008 at 2:09 am
I am doing an assignment to valuate Microsoft through having 3 different forcasted scenarios (Best, Worst, Normal) case. I calculated the WACC using 10years historical data and I got 12.11%. My problem is how to calculate the growth rate through the above different scenarios?
I calculated the average growth rate over the past 4 years and I got 20% which I feel is not logic because this means that the growth rate is less than the rate of return!!!!
Please advise!