How to Analyze Terminal Growth Rate?

Terminal growth rate might sound as distant as the farthest galaxy. Yet, it’s closer to home than you think. Imagine you’re planting a tree. Initially, it grows rapidly, but over time, the growth stabilizes.

That’s the essence of terminal growth rate in the financial universe.

Understanding the terminal growth rate in investments is like possessing a crystal ball. It helps predict the company’s performance as it transitions from a rapid growth phase to a stable and sustainable pace. Because the stock market relies on expectations, the terminal growth rate becomes a key factor.

Interestingly, the average terminal growth rate for mature economies hovers around 2 to 3 percent. This data is more than just a figure. It is a guide for investors trying to understand their investments’ uncertain future.

But why is terminal growth rate so crucial? It relates directly to valuing a company in perpetuity. Without it, investors are like sailors without a compass, guessing which way the economic winds will blow.

This blog post explores the whys and hows of terminal growth rate. We’ll explore its significance in investment decisions and how it paints a clearer picture of a company’s long-term potential. Understanding the terminal growth rate is the first step toward making informed decisions.

Table of Contents:

1. What is Terminal Value?
2. What is the Terminal Growth Rate?
3. What are the Types of Terminal Values?
4. Why Do We Calculate Terminal Growth Rate?
5. Where is the Terminal Growth Rate Used?
6. How to Calculate Terminal Growth Rate?
7. How to Examine Terminal Growth Rate?
8. Wrap Up

First…

What is Terminal Value?

Definition: Terminal value is a financial concept used in valuation models such as discounted cash flow (DCF) analysis. It represents the estimated value of an investment at the end of a certain period. Terminal value accounts for all future cash flows beyond the projection period. It assumes that the investment will continue generating cash flows indefinitely.

There are several methods to calculate a terminal value, including:

• The perpetuity growth method – assumes cash flows grow at a constant rate indefinitely.
• The exit multiple method – applies a multiple to a measure of cash flow or earnings to estimate the terminal value.

Terminal value is crucial in DCF analysis. Why? It captures an investment’s long-term value beyond the explicit forecast period, providing a comprehensive view of its worth.

What is the Terminal Growth Rate?

Definition: The terminal growth rate, also known as the perpetual growth rate, is a key parameter used in financial modeling. It represents the rate at which a company’s cash flows are expected to grow indefinitely beyond the explicit forecast period.

In DCF analysis, the terminal growth rate is a critical input. It determines the long-term sustainability and value-generation potential of the investment. This rate is typically assumed to be stable and reflects the expected growth rate of the economy or the industry in which the company operates.

It’s essential to choose a terminal growth rate that is reasonable and sustainable. Why? An overly optimistic or unrealistic rate can significantly distort valuation results. Analysts often rely on historical performance, industry benchmarks, and economic forecasts to estimate an appropriate terminal growth rate.

What are the Types of Terminal Values?

There are two primary types of terminal value: the Terminal Multiple Method and the Perpetuity Growth Method.

• Terminal Multiple Method

This approach estimates the terminal value by applying a multiple to a financial metric, such as earnings for the terminal year. The multiple is often derived from comparable companies or market transactions.

The terminal value formula for the terminal multiple method is as follows:

Terminal Value = Terminal Multiple from Last 12 Months x Projected Statistic

• Perpetuity Growth Method

Also known as the Gordon Growth Model. This method assumes that cash flows will grow at a constant rate indefinitely beyond the explicit forecast period. The terminal value formula for the perpetuity growth model is as follows:

Where:

• • Free Cash Flow = FCF from the last 12 months
  • WACC = Weighted Average Cost of Capital
  • g = Perpetuity growth rate

Why Do We Calculate Terminal Growth Rate?

Calculating the terminal growth rate is fundamental to financial analysis. Here are the reasons why we calculate the terminal growth rate:

• Estimation of terminal value: The terminal growth rate helps determine the value of an investment at the end of the forecast period. It allows analysts to capture the value of future cash flows beyond the explicit projection period.
• Projection of sustainable growth: Estimating a reasonable terminal growth rate facilitates projecting the investment’s long-term sustainable growth potential. This helps understand the company’s future performance and value-generation capability.
• Integration of economic environment: The terminal growth rate often reflects the expected growth rate of the broader economy or industry. It integrates macroeconomic factors and industry trends into the valuation process, providing a holistic view of the investment’s prospects.
• Normalization of cash flow projections: Calculating the terminal growth rate ensures cash flow projections are normalized and aligned with the company’s long-term performance outlook. It helps smooth out short-term fluctuations and capture the underlying growth trajectory.
• Alignment with investment risk and return: The terminal growth rate is a critical factor in assessing the risk and return profile of an investment. It should be aligned with:
  • The risk factors associated with the investment
  • The required rate of return expected by investors
• Assessment of business value: The terminal growth rate influences the overall valuation of the business. A higher terminal growth rate implies higher terminal value, which can significantly impact investment decisions and strategic planning.

Where is the Terminal Growth Rate Used?

The terminal growth rate is used in various financial analyses and decision-making processes across different domains. Here are some key areas where the terminal growth rate finds application:

• Discounted Cash Flow (DCF) valuation: In a DCF valuation, the terminal growth rate is utilized to calculate the final worth of an investment. It assists in determining the current value of future cash flows beyond the projected period. Therefore, it offers a thorough assessment of the investment.
• Equity and enterprise valuation: Valuation of a company’s equity or its whole enterprise requires consideration of the terminal growth rate. It affects the ultimate valuation amount, influencing choices regarding mergers and acquisitions, investing options, and maximizing shareholder value.
• Investment decision-making: Investors utilize the terminal growth rate to assess the appeal of investment opportunities when making investment decisions. It aids in evaluating a company’s future potential for growth. You can assess whether an investment matches your risk-return preferences and investment goals.
• Strategic planning: Companies use the terminal growth rate in their strategic planning procedures to steer long-term decision-making. It guides important strategic projects like capital budgeting, expansion strategies, and resource allocation. It ensures they are in line with the company’s growth goals and competitive environment.

How to Calculate Terminal Growth Rate?

Different ways exist to calculate the terminal growth rate. One option is to utilize either the industry’s average growth rate or the country’s economic growth rate. This is based on the company’s market and geographic location.

Another method is the analysis of historical growth rates. This process involves examining a company’s historical growth rate for a long period, usually five to ten years. Then, the data is used to estimate the terminal growth rate.

Analysts might also consider macroeconomic factors, industry trends, and management predictions to arrive at a reasonable estimation.

When trying to determine the terminal growth rate, it is essential to connect it with broader economic predictions. This is handy for businesses directly impacted by general economic trends. For example, assume a new sector has experienced significant growth in the recent past. Predicting a terminal growth rate above that of the overall economy could lead to inflated valuations. Over a long period, this would indicate that the company would surpass the size of the economy. This is a situation that doesn’t make sense.

Terminal growth rate formula:

Where:

• FCF(t+1) = Free cash flow expected in the next period after the explicit forecast period
• r = Discount rate (required rate of return, such as cost of equity or weighted average cost of capital)
• g = Terminal growth rate (perpetual growth rate of cash flows)

How to Examine Terminal Growth Rate?

Data analysis can feel like untangling headphone wires in the dark—frustrating and full of twists and turns. Dissecting something as slippery as terminal growth rate becomes doubly daunting. This is where the magic of data visualization comes into play.

Data visualization transforms a maze of numbers into a clear path forward. Think of it as turning a dense novel into an engaging comic book; the story leaps off the page.

Yet, when wielding Excel, it can feel like you’re armed with a blunt tool for a precision job. Excel’s charts and graphs lack the finesse and clarity needed for such a nuanced task.

Enter ChartExpo, the sharp scalpel in a world of butter knives. ChartExpo supercharges Excel’s visualization capabilities, bringing the intricate dance of terminal growth rate into the spotlight. As a result, the gleaning of insights becomes as easy as pie.

Let’s learn how to install ChartExpo in Excel.

1. Open your Excel application.
2. Open the worksheet and click the “Insert” menu.
3. You’ll see the “My Apps” option.
4. In the Office Add-ins window, click “Store” and search for ChartExpo on my Apps Store.
5. Click the “Add” button to install ChartExpo in your Excel.

ChartExpo charts are available both in Google Sheets and Microsoft Excel. Please use the following CTAs to install the tool of your choice and create beautiful visualizations with a few clicks in your favorite tool.

Example

Let’s analyze the Terminal Growth Rate sample data below using ChartExpo.

Company	Terminal Growth Rate	Revenue Growth Rate	Profit Margin
Company A	3.7	6.8	14.5
Company B	4.1	6.2	13.5
Company C	4.5	7.1	15.5
Company D	5	6.5	14.5
Company E	4	6.2	13.5

• To get started with ChartExpo, install ChartExpo in Excel.
• Now Click on My Apps from the INSERT menu.

• Choose ChartExpo from My Apps, then click Insert.

• Once it loads, scroll through the charts list to locate and choose the “Multi Axis Line Chart”.

• Click the “Create Chart From Selection” button after selecting the data from the sheet, as shown.

• ChartExpo will generate the visualization below for you.

• Click on Settings and change the “Data Representation” as follows.

• If you want to add anything to the chart, click the Edit Chart button:

• Click the pencil icon next to the Chart Header to change the title.
• It will open the properties dialog. Under the Text section, you can add a heading in Line 1 and enable Show.
• Give the appropriate title of your chart and click the Apply button.

• Add the dollar sign with the Revenue Growth Rate:

• Add the dollar sign with Terminal Growth Rate & Profit Margin.
• Change the Legend shape of Revenue Growth Rate to Column and click the Apply button.

• Change the Legend shape of the Terminal Growth Rate into a Line and Circle and click the Apply button.

• Click the “Save Changes” button to persist the changes made to the chart.

• Your final Multi Axis Line Chart will look like the one below.

Insights

• Terminal Growth Rate: Company A has an annual percentage rate of 3.7%, while Company D has a rate of 5% per year.
• Revenue Growth Rate: Fluctuates between 6.2% and 7.1% every year.
• Profit Margin: Varies between 13.5% and 15.5% in percentages.

FAQs

What is the meaning of terminal growth?

Terminal growth is the sustainable rate at which a company’s cash flows or earnings are expected to increase indefinitely beyond the forecast period. It represents the business’s long-term growth potential.

What affects terminal growth rate?

The terminal growth rate is influenced by factors such as:

• Industry dynamics
• Economic conditions
• Competitive positioning
• Technological advancements
• Company-specific factors like market share, management quality, and strategic initiatives

What are the Assumptions of the terminal growth rate?

The assumptions of the terminal growth rate include the assumption of:

• Stable economic conditions
• Consistent industry growth
• Perpetual competitive advantage for the company
• Sustainable cash flow generation
• The absence of significant changes in market dynamics or regulatory environment over the long term.

Wrap Up

The terminal growth rate plays a crucial role in financial analysis, especially in discounted cash flow (DCF) modeling. It indicates the rate at which a company’s profits are projected to grow beyond the specified forecasted time frame. This rate represents the company’s future growth opportunities, which are essential for calculating its final worth.

Careful consideration of different factors and assumptions is needed to comprehend the terminal growth rate. Analysts often depend on past results, industry standards, economic predictions, and market patterns to predict an appropriate terminal growth rate. These inputs are essential to accurately represent the company’s competitive position and industry dynamics in the growth rate.

However, it’s essential to recognize that the terminal growth rate is based on several assumptions. These assumptions include the stability of economic conditions, consistent industry growth, and perpetual competitive advantage for the company. Deviation from these assumptions could impact the accuracy of the terminal growth rate estimate and subsequent valuation outcomes.

Despite its importance, the terminal growth rate is inherently uncertain and subject to change over time. As such, sensitivity analysis is often conducted to assess the impact of variations on the valuation results. This allows stakeholders to gauge the sensitivity of the investment’s value to changes in growth assumptions.

In essence, the terminal growth rate is a key driver in estimating the long-term value of an investment. Embrace it today to make informed decisions regarding investment opportunities, strategic planning, and value-creation initiatives.