Perpetuity Growth Method
The Perpetuity Growth Method estimates terminal value by treating the final year's free cash flow as the base of a perpetually growing stream, dividing the next period's cash flow by the difference between the discount rate and the assumed long-run growth rate.
The Perpetuity Growth Method — also known as the Gordon Growth Model or the stable-growth DCF approach — is derived from the formula for the present value of a growing perpetuity. If a stream of cash flows starts at C next period and grows at rate g forever, and the appropriate discount rate is r, then the present value is C / (r - g). Applied to terminal value in a DCF model, the formula becomes: TV = FCF_{n+1} / (WACC - g), where FCF_{n+1} is the free cash flow in the first year beyond the explicit forecast, WACC is the discount rate, and g is the terminal (perpetuity) growth rate.
The terminal growth rate is one of the most consequential assumptions in equity valuation. In theory, no company can grow faster than the overall economy forever — if it did, it would eventually become the entire economy. For US companies operating in mature industries, the perpetuity growth rate is typically set between 2% and 3%, roughly in line with long-run nominal GDP growth. For companies with durable competitive advantages or operating in high-growth emerging areas, analysts sometimes use slightly higher rates, but rates above 4% invite skepticism because they imply the firm will outgrow the economy indefinitely.
The denominator (WACC - g) creates nonlinear sensitivity. As g approaches WACC, the terminal value explodes toward infinity, making the model highly unstable for growth rates close to the discount rate. A model with WACC = 8% is far more sensitive to the difference between g = 3% and g = 3.5% than a model with WACC = 12%. For US companies valued in the current 7-9% WACC range, even small movements in the growth rate assumption generate large swings in terminal value.
Analysts should ensure internal consistency: the growth rate used in the perpetuity should be consistent with the capital reinvestment assumptions embedded in the terminal-year cash flow. A company growing at 3% per year needs to reinvest capital to sustain that growth. The reinvestment rate equals g / ROIC, where ROIC is the return on invested capital. If a firm earns 10% ROIC and grows at 3%, it must reinvest 30% of NOPAT each year, reducing free cash flow relative to earnings. Failing to account for this reinvestment leads to overstated terminal free cash flows and inflated valuations.