If you're into stock valuation, you might know of terminal growth rate. It's very important when calculating a company's long-term value.
So, What Exactly is the Terminal Growth Rate?
Think of the terminal growth rate as the long-term speed limit for a company’s growth. After you’ve projected a company’s cash flows for the next five or ten years, you need to make an assumption about how it will grow beyond that period—potentially forever.
That’s where this rate comes in, and it’s a key part of discounted cash flow (DCF) analysis.
We will calculate Apple's (AAPL) terminal growth rate in today's post.
Why Does It Matter?
DCF models use the terminal growth rate to calculate the company’s terminal value, which often makes up 60-80% of the total valuation.
So, even a small tweak in this rate can have a huge impact on how much a company is worth.
If you overestimate it, you might think a stock is a steal when it’s actually overpriced. Underestimate it, and you might pass on a great investment.
How Do We Use It?
Most analysts use the Gordon Growth Model (also called the Perpetuity Growth Model) to estimate terminal value:
Where:
- TV = Terminal Value
- FCF_n = Last projected year’s Free Cash Flow
- g = Terminal Growth Rate
- r = Discount Rate (often WACC)
How Do You Pick a Realistic Terminal Growth Rate?
Since we’re talking about indefinite growth, we have to be realistic. Here are a few things to keep in mind:
- Think About the Economy – No company can outgrow the economy forever. In developed countries, long-term GDP growth is usually around 2-3%, so it’s a good upper limit for most companies.
- Consider the Industry – A mature industry (like utilities) will probably have a lower rate, while emerging industries (like tech) might justify a slightly higher one.
- Factor in Inflation & Interest Rates – If inflation is high, companies might justify a slightly higher growth rate, but don’t get carried away!
- Look at the Company’s Strengths – Is this company built to last? A dominant player with strong market share and innovation might sustain higher growth for longer.
Common Assumptions for Terminal Growth Rate
- Most companies fall in the 1.5% to 3.5% range.
- If the company is in a declining industry, it could even be 0% or negative.
- If you see someone using a rate above 4-5%, be skeptical—it’s probably too optimistic!
Example: Calculating Apple's Terminal Growth Rate
Let’s apply this to Apple (AAPL).
Suppose we have the following inputs:
- FCF_n (Free Cash Flow in the final projected year) = $120 billion
- g (Terminal Growth Rate) = 2.5%
- r (WACC) = 8%
Using the Gordon Growth Model:
This means that, under these assumptions, Apple's terminal value would be approximately $2.24 trillion.
This highlights just how important the terminal growth rate is—it plays a huge role in determining a company's valuation.
Final Thoughts
At the end of the day, the terminal growth rate is a crucial piece of the valuation puzzle. It’s easy to get caught up in big numbers, but keeping things grounded in reality is key.
Next time you’re evaluating a stock, take a close look at the terminal growth assumption—it could make all the difference between a solid investment and a costly mistake!
