Definition
The terminal growth rate (g) is the constant annual growth rate a DCF model assumes for cash flows (or dividends) forever, once the explicit multi-year forecast period ends. Because no company can outgrow the whole economy indefinitely, this rate is kept low and conservative — typically close to long-run GDP growth or inflation (roughly 2-3%).
Formula
Terminal Value = FCFₙ × (1 + g) ÷ (WACC − g)
FCFₙ = Free cash flow in the final explicit forecast year
g = Terminal growth rate — assumed to continue forever
WACC = Discount rate (must be greater than g, or the formula breaks)
A terminal growth rate set too high — above the discount rate, or above realistic long-run economic growth — makes the terminal value (and the whole valuation) balloon toward infinity. This is one of the most common ways a DCF gets manipulated to produce whatever answer someone wants.
Worked example
Worked example
Year-5 free cash flow (FCFₙ)$100M
Terminal growth rate (g)2.5%
WACC8.0%
Terminal Value = $100M × 1.025 ÷ (0.08 − 0.025)$1,863.6M
Raising g from 2.5% to just 3.5% (still a modest-looking change) pushes Terminal Value to $100M × 1.035 ÷ (0.08 − 0.035) = $2,300M — a 23% jump in terminal value from a 1 percentage point tweak. This sensitivity is why terminal growth should stay conservative and grounded in real long-run economic growth, not a company's recent momentum.