How to Estimate the Long-Term Growth Rate


As a corporate finance professional, one of the most important parameters you will be estimating is the long-term or terminal growth rate (g), which you will need in order to:

  • value a company with a terminal value (i.e. assumed to operate in perpetuity),

  • review a third-party valuation,

  • assist the audit team in performing their annual impairment testing, or

  • assess the achievability of financial projections provided to you by your client.

The g used to estimate the terminal value of a company should generally be consistent with the long-term inflation rate (consumer price index, or "CPI") of the country in which that company operates. Alternatively, the long-term gross domestic product ("GDP") growth rate may also be considered as a proxy for g, but the inflation rate is more commonly used.


Based on your team's practices, the g is estimated as either:

  1. the average inflation rate expected across the forecast period, or

  2. the inflation rate expected in the final year of the forecast period.

In general, you would expect the long-term inflation rate to be aligned to the target set by the relevant Central Bank. For example, if you are valuing a company located in the euro area, it is good practice to consider a g in line with the ECB's 2% inflation target.

NB: if your company generates earnings or cashflows in more than one country, you will need to calculate a blended g based on the contribution of the individual countries to the company's total earnings or free cash flows.

If you are valuing a company using an income approach (i.e. DCF), always aim to reach the steady state growth by your last year of projection: if necessary, you can always stretch your forecast period, say, from 5 to 10 years. This may be tricky, especially in the case of startups, which are expected to exhibit exponential growth in their early stages. Also, the longer the projection period, the more assumptions you need to take, and the higher the risk that forecasts lose relevance, meaningfulness and likeliness. In any case, you should avoid applying a terminal growth rate that exceeds the relevant country’s long-term growth rate: it would be like assuming that the company will constantly outperform the domestic market and, eventually, grow to become larger in size than the whole economy.


With specific reference to high-growth firms, have a read through Prof. Aswath Damodaran's short post "How long will high growth last?", regarding the sustainability of high growth, and its impact on value creation.

Sources


Here is a list of the most commonly used private sources of macroeconomic indicator forecasts, to which advisors may have access through their firm:

  1. Economist Intelligence Unit ("EIU") - this is probably the most used private source of future inflation and GDP growth rates, with forecasts being provided for a period of at least 5 years. The EIU also provides long-term inflation rate averages across several decades, which may be helpful to cross-check the assumptions underlying financial projections and valuations.

  2. Bloomberg terminal - under the "WECO" function you can find macroeconomic forecasts for individual countries and regions.

  3. Oxford Economics - macroeconomic forecasts are provided for a period of at least 5 years. This source is pricy and your firm will probably not have a subscription to it, but we recommend you request a free trial to check it out.

  4. Consensus Economics - long-term forecasts are provided for individual countries (50+) and regions in an annual report, with GDP growth and inflation rates forecasted for several decades.

If you do not have access to any of the above, you can always turn to the following public sources of macroeconomic indicator forecasts:

  1. IMF’s World Economic Outlook (WEO) - this is probably the most used public source of expected inflation an GDP growth rates, with forecasts of major economic indicators updated twice a year. Here's the link to the October 2020 Excel database.

  2. OECD Economic Outlook - the OECD provides 2-year projections of major economic indicators for its Member States, updated twice a year. Here's the link to the December 2020 report.

  3. European Commission website - the EC publishes a full set of 2-year forecasts for the EU and its Member States in May and November, and interim updates of GDP and inflation forecasts in February and July. Here's the link to the Winter 2021 forecast statistical annex.

  4. Lastly, you may find short-term forecasts of inflation and GDP growth rates on the websites of the relevant Central Bank (Bundesbank for Germany, Federal Reserve for the US, Banca d’Italia for Italy, Bank of England for UK, etc.) or national statistics authority (ONS for UK, ISTAT for Italy, etc.).

We hope you found this article useful. Make sure to download our Excel template for the g estimation:

B4C_Template_g
.xlsx
Download XLSX • 164KB

The template already includes the IMF inflation and GDP growth forecasts for all countries and regions (October 2020 data, the latest available at the date of publication of this article).


Also, you can easily blend the g by simply selecting the desired countries and entering their respective contributions in the 'Input' tab: the output will update automatically at the 'g' tab.


For questions or clarifications, feel free to reach out. Thanks for reading, and good luck!

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