How to Calculate Terminal Growth Rate in Dcf

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Terminal Growth Rate Calculator

Method 1: Sustainable Growth Rate

Calculates growth based on company performance (ROE and Retention).

Method 2: Implied Terminal Growth Rate

Calculates the growth rate implied by a specific Terminal Value (Gordon Growth Reverse).

function calculateSustainableGrowth() { var netIncome = parseFloat(document.getElementById("netIncome").value); var dividends = parseFloat(document.getElementById("dividends").value); var equity = parseFloat(document.getElementById("totalEquity").value); if (isNaN(netIncome) || isNaN(dividends) || isNaN(equity) || equity <= 0 || netIncome <= 0) { document.getElementById("sustainableResult").innerHTML = "Please enter valid financial data."; return; } var roe = netIncome / equity; var retentionRatio = (netIncome – dividends) / netIncome; var sgr = (roe * retentionRatio) * 100; document.getElementById("sustainableResult").innerHTML = "Sustainable Growth Rate: " + sgr.toFixed(2) + "%"; } function calculateImpliedGrowth() { var tv = parseFloat(document.getElementById("terminalValue").value); var fcf = parseFloat(document.getElementById("finalYearFCF").value); var wacc = parseFloat(document.getElementById("wacc").value) / 100; if (isNaN(tv) || isNaN(fcf) || isNaN(wacc) || (tv + fcf) === 0) { document.getElementById("impliedResult").innerHTML = "Please check your inputs."; return; } // Formula: g = (TV * WACC – FCF_n) / (TV + FCF_n) var g = ((tv * wacc) – fcf) / (tv + fcf); var result = g * 100; document.getElementById("impliedResult").innerHTML = "Implied Growth Rate: " + result.toFixed(2) + "%"; }

Understanding Terminal Growth Rate in DCF Analysis

The Terminal Growth Rate (TGR) is a critical assumption used in Discounted Cash Flow (DCF) modeling to estimate the value of a business beyond the explicit forecast period. Since a company is assumed to operate indefinitely, we use the terminal growth rate to value all future cash flows from the final forecast year into infinity.

How to Calculate Terminal Growth Rate: Two Main Approaches

Analysts typically use two primary methods to derive the terminal growth rate. Choosing the right one depends on the stability of the company and the available data.

1. The Gordon Growth Method (Perpetuity)

The most common method is the Gordon Growth Model. In this approach, we assume the company's Free Cash Flow (FCF) will grow at a constant rate forever. Usually, this rate is set between the long-term inflation rate and the historical GDP growth rate (typically 2% to 3%).

Formula: Terminal Value = [FCFn × (1 + g)] / (WACC – g)

2. The Sustainable Growth Rate Method

The Sustainable Growth Rate (SGR) is based on how much a company can grow without needing to take on additional financial leverage. It relies on the Retention Ratio (how much profit is kept in the business) and Return on Equity (ROE).

  • ROE: Net Income / Shareholder's Equity
  • Retention Ratio: 1 – (Dividends / Net Income)
  • SGR: ROE × Retention Ratio

Example Calculation

Suppose a company has the following financials at the end of Year 5 (the final forecast year):

  • ✅ Final Year FCF: $800,000
  • ✅ WACC: 10%
  • ✅ Target Terminal Value: $10,000,000

By reversing the Gordon Growth formula, we find the Implied Terminal Growth Rate. Using the logic in our calculator above, the result would be 1.85%. This is a realistic figure, as it sits just below long-term economic growth expectations.

Important Constraints

When selecting a terminal growth rate, keep these professional standards in mind:

  1. Never exceed GDP growth: If a company grows faster than the global economy forever, it would eventually become the entire economy.
  2. Relationship with WACC: The growth rate (g) must always be less than the Weighted Average Cost of Capital (WACC). If g > WACC, the formula results in a negative value, which is mathematically invalid in valuation.
  3. Consistency: Ensure the growth rate reflects the mature state of the industry. Tech firms might have higher initial growth, but their terminal rate should align with utility-like stability.

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