Perpetuity growth method
DCFCalculating terminal value by assuming the final year cash flow grows forever at a constant modest rate.
Also written: Gordon growth method, perpetuity growth
The formula takes the year after the final forecast year, divides it by the discount rate less the growth rate, and discounts the result back. It capitalises a growing perpetuity.
The denominator is a small difference between two larger numbers, which is what makes it so sensitive. At a 9% WACC, moving growth from 2% to 3% cuts the denominator from 7% to 6% and raises terminal value by roughly 17%, with nothing about the business having changed.
The growth rate has hard bounds. It cannot exceed long run nominal GDP in the currency of the cash flows, or the company eventually becomes the entire economy, and it should reflect the reinvestment the business must make to achieve it.
It is intrinsically consistent, since it depends on your own assumptions rather than the market's, which is why it is usually the primary method with an exit multiple used as the cross check.
Worked example
Final year free cash flow of 60, WACC of 9%, terminal growth of 2.5%.
Terminal value is 60 times 1.025, divided by 0.09 less 0.025, so 61.5 over 0.065, which is 946.
Move growth to 3.5% and the denominator falls to 5.5%, giving 1,129. A single point of growth added 19% to the terminal value, and the terminal value is usually most of the DCF.