Terminal Growth Rate
Also written Terminal Growth Rate (g) · Terminal growth rate (g)
The constant rate at which free cash flow is assumed to grow forever after the explicit forecast period — the "g" in terminal value = FCF(T+1) / (WACC − g). In young companies it can drive most of the value.
In plain language
No one can forecast a company year by year for ever. A DCF therefore forecasts a few years in detail and then makes one sweeping assumption about everything after: that cash flow keeps growing at a steady rate for good. That steady rate is the terminal growth rate.
It looks like a small input. It is not. The workbook warns that the consideration of the terminal growth rate "is very significant as it influences the value of shares almost all by itself in young companies". Since venture capital and private equity funds deal with young and growing unlisted companies, it "could be an important parameter for the investor to consider" whenever DCF analysis is used.
How it works
The terminal value formula (section 11.6, Step 2):
Terminal Value of FCF = FCF(T+1) / (WACC − g)
where T is the last year of the forecast period, g is — in the workbook's words — "the expected growth rate of PAT after the discrete period", and WACC is the weighted average cost of capital. In the worked example the terminal value is calculated as FCF of Year 5 × (1 + g) / (WACC − g).
How to choose g. The workbook's guidance:
- For consolidated industries, terminal growth rates are normally considered at 2–3% above the inflation rate. So if inflation is 3%, the growth rate could be about 5–6%.
- In high growth or sunrise industries expected to maintain significant growth for a long time, there is justification for higher terminal growth rates.
The worked example. WACC 11.35%, terminal growth rate assumed at 5%. Terminal value Rs 43,062.54 lakh, discounted at the terminal value factor of 0.5245 to Rs 22,586.53 lakh. The present value of the five forecast years is only Rs 6,935.04 lakh. Enterprise value Rs 29,521.57 lakh — so about three-quarters of the value sits in the terminal value.
The start-up illustration (Annexure 11.1). Discounting at 20%, a terminal value from a revenue multiple of 2 gives an enterprise value of Rs 187.75 lakh and, after an illiquidity discount, Rs 169 lakh. Assuming a long-term growth rate of 5% instead gives a terminal value of 46.4 × 1.05 / (0.20 − 0.05) = 325, enterprise value Rs 282.75 lakh and equity valuation Rs 254.75 lakh. The workbook's conclusion: assuming long-term growth rates "provides a significantly higher valuation", and for companies making losses or lower revenues the terminal value "will form the bulk of the enterprise value".
The formula
Terminal Value = FCF(T+1) / (WACC − g)
= FCF(T) × (1 + g) / (WACC − g)
PV of Terminal Value = Terminal Value × discount factor
A worked example
Illustrative figures. A Category I AIF is valuing a Bengaluru SaaS company. Its free cash flow in the last forecast year is Rs 20 crore and its WACC is 12%. The deal team argues over g.
g = 5%: TV = 20 × 1.05 / (0.12 − 0.05) = 21.0 / 0.07 = Rs 300 crore
g = 7%: TV = 20 × 1.07 / (0.12 − 0.07) = 21.4 / 0.05 = Rs 428 crore
Two percentage points on g add Rs 128 crore — about 43% — to the terminal value, before a single forecast year has changed.
Using the workbook's guidance: if inflation is taken at 3%, a consolidated industry would justify about 5–6%. The founders argue that SaaS is a sunrise industry and 7% is defensible. The fund's investment committee will want to see the valuation at both, because at this company's stage the choice of g is doing most of the valuing.
What g can never be is 12% or more. At g = WACC the denominator is zero, and above it the formula gives a negative value — a sign the assumption is impossible, not that the company is worthless.
Why NISM asks about it
Chapter 11 (Valuation) introduces the terminal value at 11.6 Step 2, gives the terminal growth rate guidance immediately after the WACC box, and applies it in the Step 4 DCF table; Annexure 11.1 repeats the exercise for a start-up. The chapter's sample question defines terminal value as "the continuing value beyond the discrete period". Expect the formula, the inflation-plus-2–3% rule of thumb, and the point that the terminal growth rate drives value in young companies.
Common exam traps
- Terminal value is the continuing value beyond the discrete (forecast) period — not the value at the end of a company's life and not an acquisition value.
- g must be below WACC. The formula breaks down otherwise.
- Consolidated industries: 2–3% above inflation. Sunrise industries: higher is justified. With inflation at 3%, that is about 5–6%.
- Use FCF of T+1, not of T. Growing the last forecast year by (1 + g) first is part of the formula.
- Workbook arithmetic to be aware of. Recomputing 2,606.17 × 1.05 / 0.0635 gives about Rs 43,094 lakh, slightly above the printed Rs 43,062.54 lakh; and the start-up illustration grows the discounted Year 3 figure of 46.4 rather than Year 3 revenue of 80. For exam computations, follow the figures and steps the question gives you.
Where this is taught
- Series XIX-A · Chapter 11: Valuationintroduced here
- Series XIX-C · Chapter 14: Valuationintroduced here
- Series XIX-D · Chapter 11: Valuationintroduced here
Related terms
- Discounted Cash FlowA valuation method that estimates the cash a business will generate in future years and converts each year back to what it is worth today.
- InflationA sustained general rise in the price level, which erodes what a rupee buys — and the reason a nominal return has to be deflated before it means anything.
- Terminal valueThe value of everything a business earns after the end of the explicit forecast period, capitalised as a perpetuity or an exit multiple and then discounted back — usually most of a DCF answer.
- WACCThe blended after-tax rate a company pays on all its capital, equity and debt weighted by how much of each it uses — and therefore the discount rate for free cash flow to the firm.
- Free Cash FlowThe cash a company generates from operations after reinvesting in working capital and routine capital expenditure — the figure a DCF valuation projects for about five years and discounts at WACC.
- Venture Capitalist MethodA start-up valuation method: estimate the company's value at exit, discount it at the VC's target return, and set the stake needed for the investment — adjusted upward for future dilution.
- Sunrise sectorsNewly emerging sectors around which AIF investment themes are being built — new-generation technologies and ESG, including AI, virtual and artificial reality, green energy and sustainability.
- Specific Company Risk PremiumAn extra slice added to the discount rate for one particular company, on top of beta and the market risk premium, to price the unsystematic risk that the CAPM does not capture.