What is the Perpetuity Growth Method When Calculating Terminal Value?
Dec 10
/
themodelingschool
What is the Perpetuity Growth Method When Calculating Terminal Value?
The Perpetuity Growth Method is a widely used approach for estimating Terminal Value in business valuation and financial modeling. Terminal Value accounts for the value of a company beyond the forecast period, often comprising a significant portion of the total valuation. The Perpetuity Growth Method calculates Terminal Value by assuming that the company will generate cash flows indefinitely, growing at a stable rate.
This blog will explain the Perpetuity Growth Method, its formula, steps, examples, and when to use it.
Understanding Terminal Value
Terminal Value represents the present value of all future cash flows beyond the explicit forecast period. Without it, the valuation would exclude the company’s long-term value as a going concern.
There are two main methods for calculating Terminal Value:
1. Perpetuity Growth Method (focus of this blog).
2. Exit Multiple Method.
Perpetuity Growth Method: Definition and Formula
The Perpetuity Growth Method assumes the company’s free cash flows will grow at a constant rate indefinitely. This method uses the Gordon Growth Model to estimate Terminal Value.
Formula:
Terminal Value=FCFn+1/(WACC−g)
Where:
- FCFn+1: Free cash flow for the first year beyond the forecast period.
- WACC: Weighted Average Cost of Capital (discount rate).
- g: Perpetual growth rate (assumed constant).
Steps to Calculate Terminal Value Using the Perpetuity Growth Method
Step 1: Forecast Free Cash Flow (FCFn+1)
Estimate the company’s free cash flow for the first year after the forecast period (year n+1). This is often based on the final year’s cash flow from the explicit forecast, adjusted for the expected growth rate.
Step 2: Determine the Perpetual Growth Rate (g)
Choose a stable, realistic growth rate that reflects long-term economic and industry conditions. The growth rate should not exceed the economy's expected growth rate (e.g., GDP growth). Typical values range between 2% and 4%.
Step 3: Identify the Discount Rate (WACC)
Calculate the company’s Weighted Average Cost of Capital (WACC), representing the required rate of return for investors.
Step 4: Apply the Formula
Substitute the FCFn+1, WACC, and g into the Perpetuity Growth formula to calculate Terminal Value.
Advantages of the Perpetuity Growth Method
1. Accounts for Long-Term Growth:
Reflects the company’s ability to generate cash flows indefinitely.
2. Straightforward Formula:
Easy to calculate if WACC and growth rate assumptions are clear.
3. Economic Alignment
:Assumes a realistic and sustainable growth rate tied to economic fundamentals.
Limitations of the Perpetuity Growth Method
1. Sensitivity to Assumptions:
Small changes in the growth rate (g) or discount rate (WACC) can significantly impact Terminal Value.
2. Difficult to Estimate Long-Term Growth:
Selecting an appropriate perpetual growth rate requires judgment and can be challenging in volatile industries.
3. Risk of Overvaluation:
Unrealistically high growth rates can inflate Terminal Value, leading to an overvaluation of the business.
When to Use the Perpetuity Growth Method
- Long-Term Stability: Use this method when the company operates in a mature, stable industry with predictable cash flows.
- Economic Growth Alignment: Ideal for businesses expected to grow at or below the economy's long-term growth rate.
- Lack of Market Comparables: Preferable when market multiples for comparable companies are unavailable or unreliable.
Conclusion
The Perpetuity Growth Method is a powerful tool for estimating Terminal Value, especially for companies with stable, long-term growth prospects. By leveraging the Gordon Growth Model, this method provides a systematic way to value a business’s cash flows beyond the forecast period.
