How do you compare terminal growth rate in DCF with industry growth and GDP growth? (2024)

Terminal growth rate in DCF is the annual rate at which the company's free cash flows are expected to grow in perpetuity after the forecast period. It is used to calculate the terminal value, which is a major component of the DCF valuation. Terminal growth rate in DCF should be realistic and conservative, as it can have a significant impact on the final valuation. A higher terminal growth rate implies a higher terminal value and a higher DCF valuation, and vice versa.

One of the ways to assess the reasonableness of the terminal growth rate in DCF is to compare it with the expected growth rate of the industry in which the company operates. The industry growth rate reflects the market size, demand, competition, innovation, and regulation of the sector. It can provide a benchmark for the company's long-term growth potential and market share. Generally, the terminal growth rate in DCF should not exceed the industry growth rate, unless the company has a sustainable competitive advantage or a niche market position that allows it to outperform its peers.

Another way to evaluate the terminal growth rate in DCF is to compare it with the expected growth rate of the economy or the gross domestic product (GDP). The GDP growth rate reflects the overall economic activity, income, consumption, investment, and trade of a country or a region. It can indicate the macroeconomic environment and the business cycle that affect the company's performance and prospects. Typically, the terminal growth rate in DCF should not be higher than the GDP growth rate, as it is unlikely that the company can grow faster than the economy indefinitely.

There are different sources and methods to estimate the industry growth and GDP growth rates for the terminal value calculation. Some of the common sources include industry reports, market research, analyst forecasts, historical data, and government statistics. Some of the common methods include using the historical average, the trend analysis, the regression analysis, or the scenario analysis. Depending on the availability and reliability of the data, you may need to use more than one source or method to cross-check and validate your estimates.

When you compare terminal growth rate in DCF with industry growth and GDP growth, you should also consider the risk and uncertainty factors that may affect the company's future cash flows. For example, you may need to adjust the terminal growth rate downward if the company faces high competition, low profitability, regulatory changes, technological disruption, or environmental issues. Conversely, you may need to adjust the terminal growth rate upward if the company has strong competitive advantage, high profitability, favorable regulation, technological innovation, or social impact.

Finally, after you choose a terminal growth rate in DCF that is consistent with the industry growth and GDP growth, you should test its sensitivity and robustness in your DCF valuation. You can do this by changing the terminal growth rate by a small percentage and observing how it affects the DCF value and the implied valuation multiples. You can also compare your DCF value with other valuation methods, such as comparable companies or transactions, to check for any significant discrepancies or anomalies. By testing terminal growth rate sensitivity in DCF, you can ensure that your valuation is reasonable and reliable.

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