Fade period
DCFYears inserted between the explicit forecast and the terminal value in which growth, margin and returns converge toward sustainable levels.
Also written: fade, transition period, three stage DCF
A two stage DCF steps from a high growth forecast straight into a perpetuity, which asserts that a business growing fifteen per cent in December grows at two per cent in January and does so forever. A fade period replaces that cliff with a glide, tapering growth, margin and return on invested capital toward terminal levels across several years.
The economic argument is competitive rather than mathematical. Returns above the cost of capital attract entry, imitation and substitution, so excess returns erode. Fading return on invested capital toward WACC is the defensible default precisely because it requires no view on how long a specific advantage lasts.
It also disciplines reinvestment. Growth costs capital, so a fade that lowers growth should lower the reinvestment rate alongside it, since growth equals reinvestment multiplied by return on invested capital. A fade applied to growth alone, with capex left at its high growth level, understates cash flow rather than improving the model.
There is a trap in the other direction. Extending a forecast with a generous fade rather than the abrupt drop the terminal rate already implied raises the valuation, and the increase comes from the extra years of above inflation growth now assumed, not from the greater length of the model. That is a real assumption change and should be defended as one.
Worked example
An illustrative business grows 8% for five years then 2% forever, at a 9% WACC. Enterprise value is 1,878 whether the model runs five years or ten, because the path is identical.
Rebuild it fading growth from 8% to 2% across years six to ten and enterprise value rises to 2,079, about 11% higher, while the terminal value share barely moves.
The extra 201 did not come from forecasting further out. It came from assuming five more years of above inflation growth, which is a claim about the business rather than about the model.