If you are involved in shareholder disputes or other situations requiring a business valuation, you will likely encounter valuations using the income approach to valuation. A common income approach method is the Discounted Cash Flow (DCF) method. Under the DCF method the valuator necessarily calculates a terminal value to discount that value back to the valuation date. To calculate a terminal value, a valuation professional uses the discount rate minus a long-term or sustainable growth rate.
A common position among valuation professionals is that a terminal growth rate should not exceed the sustainable growth rate because, in theory (and by definition), growing beyond a sustainable growth rate would be unsustainable at some point in the future. Conceptually, this makes sense, except when you do the math.1 As seen in the table below, it takes 26 years to accrue 99% of the present value of an amount with a 0% growth rate, 29 years with a 2% growth rate 2 and 38 years with a 6% growth rate.
In effect, most of the value is achieved over a long period. For example, if a business is in an industry that has sustained, or is expected to sustain, a 6% growth rate, it might make sense to use a 6% growth rate since almost all of the value occurs within 36 years. This is consistent with the average life expectancy of a multinational corporation or its equivalent which is between 40 and 50 years. This also suggests that automatically ruling out use of a terminal growth rate above 2% does not make sense in many circumstances.
1 See, for example, Keith F. Sellers, Adam Greiner & Philipp Schaberl, Quantifying Terminal Growth Rates: Some Empirical Evidence, The Value Examiner (November/December 2013).
2 2% or a percentage approximating 2% is commonly used in valuations because it approximates the inflation rate.
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