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Historical growth
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Industry growth
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Terminal growth
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Sensitivity analysis
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Here’s what else to consider
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A discounted cash flow (DCF) model is a widely used valuation method that estimates the present value of a company or project based on its expected future cash flows. One of the key inputs in a DCF model is the growth rate, which reflects how much the cash flows are expected to increase or decrease over time. How do you determine the growth rate in a DCF model? Here are some tips and best practices to help you choose the right growth rate for your analysis.
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1 Historical growth
One way to estimate the growth rate in a DCF model is to look at the historical growth of the company or project. You can use the past financial statements or projections to calculate the average annual growth rate of the cash flows over a certain period. This method assumes that the company or project will continue to grow at a similar rate in the future. However, this may not be realistic or accurate, especially if the company or project is facing changes in the market, competition, technology, or regulations. Therefore, you should always adjust the historical growth rate based on your assumptions and expectations about the future performance and risks.
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2 Industry growth
Another way to estimate the growth rate in a DCF model is to look at the industry growth. You can use industry reports, benchmarks, or peer comparisons to find out the average growth rate of the industry or sector that the company or project belongs to. This method assumes that the company or project will grow at the same rate as the industry or sector in the future. However, this may not be representative or relevant, especially if the company or project has a different competitive position, market share, or value proposition than the industry or sector average. Therefore, you should always adjust the industry growth rate based on your analysis and judgment of the company or project's strengths and weaknesses.
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3 Terminal growth
A third way to estimate the growth rate in a DCF model is to use a terminal growth rate. This is the growth rate that applies to the cash flows beyond the forecast period, which is usually five to ten years. The terminal growth rate represents the long-term growth potential of the company or project, and it is often assumed to be equal to or lower than the inflation rate, the GDP growth rate, or the industry growth rate. This method assumes that the company or project will reach a steady state of growth in the future, and that the cash flows will grow at a constant rate indefinitely. However, this may not be realistic or conservative, especially if the company or project is subject to uncertainties, disruptions, or declines in the future. Therefore, you should always use a reasonable and prudent terminal growth rate that reflects your assumptions and scenarios about the future.
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4 Sensitivity analysis
A final way to estimate the growth rate in a DCF model is to perform a sensitivity analysis. This is a technique that allows you to test how the valuation changes when you vary the growth rate and other key inputs in the model. You can use a sensitivity table, a scenario analysis, or a Monte Carlo simulation to show the range of possible values and outcomes based on different assumptions and probabilities. This method helps you to assess the impact and uncertainty of the growth rate on the valuation, and to identify the key drivers and risks of the company or project. Therefore, you should always conduct a sensitivity analysis to validate and refine your growth rate estimates and to communicate your findings and recommendations.
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5 Here’s what else to consider
This is a space to share examples, stories, or insights that don’t fit into any of the previous sections. What else would you like to add?
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