Why Small Changes in Perpetual Growth Can Sharply Change DCF Value
Perpetual growth drives value beyond the explicit forecast period. Calculate sensitivity while checking the discount-rate spread, next-year cash flow, and the reinvestment needed to support growth.
In a stable-growth model, terminal value equals next-year cash flow divided by the difference between the discount rate and the perpetual growth rate. As that spread narrows, value becomes more sensitive, so a small growth adjustment can sharply increase the result. The growth assumption must also be consistent with the business’s long-term scale and reinvestment requirements.
Distinguish the final forecast year from the following year
If you forecast five years of cash flow, terminal value at the end of year 5 uses year 6 cash flow. Apply the growth rate once to year 5 cash flow to obtain the following year’s figure, then divide by the discount rate minus the growth rate. Discount the resulting terminal value for five years to obtain present value. Using final-year cash flow without applying growth, or applying growth again to cash flow that already includes it, creates errors in opposite directions. Including the reference year in cell labels can reduce confusion.
Perpetual growth faces business constraints
The perpetual growth rate differs from revenue growth over the next year or two. It is difficult to justify a very large company outgrowing the entire economy indefinitely. Align the assumption with inflation in the currency used for cash flows and the business’s long-term growth potential; growth must be below the discount rate for the model to work. A positive denominator alone does not establish economic plausibility. For businesses producing finite resources or facing a defined end date, examine remaining operating life or disposal value instead of assuming perpetual growth.
Revisit reinvestment when changing growth
Increasing growth while holding capital expenditure and working capital unchanged may effectively assume free growth. Check that mature-stage margins, returns on capital, and reinvestment rates are linked, and deduct the cash required to sustain higher growth. Use a sensitivity table to show combinations of low, base, and high growth with several discount rates. If terminal value accounts for most of total value, validating long-term assumptions matters more than refining near-term earnings forecasts. That proportion alone does not prove an error, but it requires more explanation.
Worked example
Hypothetical example: With final-year FCFF of KRW 10 billion and a discount rate of 8%, calculate mechanical sensitivity while holding other conditions constant. At 2% growth, next-year cash flow of KRW 10.2 billion divided by 6% gives terminal value of KRW 170 billion. At 3% growth, KRW 10.3 billion ÷ 5% = KRW 206 billion, an increase of approximately 21.18%. In an actual analysis, first revise reinvestment for the higher growth rate, then discount the result to the present.
What to check
- Have you used cash flow from the year after the final forecast year in terminal value?
- Is perpetual growth below the discount rate and consistent with long-term business scale?
- Have you recalculated reinvestment when changing growth?
- Have you shown the present value of terminal value as a share of total value?
Sources and primary materials
This is educational material about research methods. For an actual company decision, verify the filings and primary sources for the relevant period.