What does "terminal growth rate" indicate in a DCF model?

The terminal growth rate is a crucial component of a Discounted Cash Flow (DCF) model as it reflects the anticipated long-term growth of cash flows beyond the explicit projection period. This growth rate is used to estimate cash flows in perpetuity, signifying a stable and continual increase in the company’s cash generation over time. The logic behind this assumption is that, while the initial forecasted cash flows are based on specific conditions and growth periods, the terminal growth rate captures the ongoing growth that a mature business is likely to experience as it continues its operations.

This rate is typically set at a conservative figure, often aligning with or slightly below the long-term growth rate of the economy, acknowledging that businesses cannot grow indefinitely at accelerated rates. By applying this terminal growth rate in the DCF model, analysts can derive the terminal value, which contributes significantly to the overall valuation, particularly for businesses expected to maintain a competitive advantage and stable growth over the long term. Understanding the concept of terminal growth is essential for creating realistic valuation projections.