The long-term rate at which a company’s free cash flow is projected to grow perpetually is a crucial component of valuation models like the Discounted Cash Flow (DCF) analysis. This rate represents the anticipated annual increase in cash flows beyond the explicit forecast period, assuming a stable and mature growth phase. For example, if a company’s free cash flow is expected to be $1 million at the end of the explicit forecast period, and the chosen rate is 3%, the model assumes this cash flow will increase by 3% each year indefinitely.
Accurately estimating this perpetual increase is paramount because it significantly impacts the intrinsic value derived from the DCF model. Overstating the growth rate can lead to inflated valuations, while understating it can result in undervaluing the company. Historically, analysts have relied on various macroeconomic indicators and industry trends to inform their assumptions, recognizing that no company can sustainably outgrow the overall economy in the very long term. Its correct utilization allows for a more accurate appraisal of long-term investment potential, facilitating better decision-making.
