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Series 79 practice questionmediumTerminal Value Calculation

If an analyst uses a perpetuity growth rate of 5% in the terminal value calculation for a US-based company, what concern should a senior banker raise?

  1. AThe growth rate is too low to capture the company's potential
  2. BThe perpetuity growth rate must always be zero
  3. CThe growth rate should match the company's historical revenue CAGR
  4. D5% exceeds long-term nominal GDP and implies unrealistic perpetual outgrowth✓ Correct answer
Explanation

Why D — 5% exceeds long-term nominal GDP and implies unrealistic perpetual outgrowth

A perpetuity growth rate of 5% is generally considered too high for a terminal value calculation because it exceeds the long-term nominal GDP growth rate of the US (typically assumed at 2-3%). Using a growth rate above GDP implies the company will continuously gain market share indefinitely and eventually become larger than the entire economy, which is mathematically impossible. Standard practice is to use a terminal growth rate between 2-3% for US companies, roughly in line with expected long-term nominal GDP growth.

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