What Is the Perpetuity Growth Method?
A DCF can only forecast cash flows in detail for a limited window, usually five to ten years, yet companies are assumed to operate indefinitely. The perpetuity growth method captures everything beyond the forecast by treating the business as a growing perpetuity: a stream of cash flows that increases at a steady rate g forever and can therefore be valued with a closed-form formula.
Because terminal value routinely represents 60% to 80% of total DCF value, the growth rate chosen here is one of the most consequential assumptions in the entire model. It is the intrinsic, academically grounded alternative to the exit multiple method, which borrows its answer from market pricing.
The Formula and a Worked Example
Terminal Value = Final Year FCF x (1 + g) / (WACC - g), stated as of the last forecast year and then discounted back to the present like any other cash flow. The growth rate must sit below the discount rate for the formula to work, and in practice it should not exceed long-run nominal GDP growth; most US models use something between 2% and 3%, roughly in line with expected inflation plus modest real growth.
Suppose year-five unlevered free cash flow is $200 million, WACC is 9%, and g is 2.5%. Terminal value equals $200 x 1.025 / (0.09 - 0.025) = $205 / 0.065 = $3,154 million as of year five, which discounts to $3,154 / 1.09^5 = $2,050 million of present value. Note how sensitive the output is: raising g to 3.5% pushes terminal value to $3,764 million, nearly 20% higher.
Why It Matters and How Bankers Sanity-Check It
The method's strength is that it forces an explicit, defensible statement about long-term growth rather than importing today's market multiples into an intrinsic valuation. Its weakness is extreme sensitivity: because WACC minus g sits in the denominator, small changes in either input swing the answer dramatically, which is why DCF outputs are always presented with sensitivity tables across both variables.
Practitioners cross-check the result by computing the implied exit multiple, dividing the terminal value by final-year EBITDA, and asking whether that multiple looks reasonable against where comparable companies trade. An implied 25x EBITDA multiple from a 3% growth assumption signals that the perpetuity inputs are too aggressive. Interviewers regularly ask candidates to perform exactly this cross-check in both directions.
