What long-term growth rate would you pick for a DCF, and why not 6%?
Give about 2% to 3% for a mature company, never above long-run nominal economic growth. Reject 6% for three reasons: it lasts forever, growth needs reinvestment the cash flow ignores, and the terminal value balloons as growth nears WACC.
Updated
How a 90-point answer starts
For a mature company in a developed market I'd use something like 2% to 3%, around long-run inflation or a little above, and never above the long-run nominal growth of the economy it sells into. I'd present it as an assumption, not a forecast.
See the full answer, the 50 and 70 versions, and what moves each score up.
Practice this question freeThe numbers, step by step
Next year's free cash flow is $100 and WACC is 9%. Reinvestment uses a 12% return on new capital.
- Terminal value at 2% growth$100 ÷ (9% − 2%)
- about $1,429
- Terminal value at 6% growth$100 ÷ (9% − 6%)
- about $3,333
- How much bigger$3,333 ÷ $1,429
- about 2.3 times
- Share of profit reinvested at 6%6% ÷ 12%
- 50%
What the interviewer listens for
- Do you give a range of about 2% to 3% with a reason?
- Do you say terminal growth can't beat long-run economic growth?
- Do you link growth to reinvestment?
- Can you show how sensitive the formula is as growth nears WACC?
Common mistakes
- Picking the rate the company grew at recently.The terminal rate applies forever, not for the next few years.
- Raising growth without raising reinvestment, which inflates growth and cash flow at the same time.
- Quoting today's GDP or inflation figure as fact.Describe the anchor and state your number as an assumption.
- Mixing a real growth rate with a nominal WACC, which understates the value.
Likely follow-ups
- Can terminal growth be negative?Yes, for a business in structural decline. The formula still works as long as growth stays below WACC.
- With $100 of after-tax operating profit, 3% growth and a 12% return on new capital, what's free cash flow?The reinvestment rate is 3% over 12%, or 25%, so free cash flow is $100 times 75%, which is $75.
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