Choosing a Perpetuity Growth Rate for Equity Valuation

Summary

The document discusses how to choose a long-run growth or discount assumption for a perpetuity in firm valuation. One response suggests linking the rate to the valuation model and using a risk-free rate reduced by three percentage points for earnings-based models. Another gives a reference assumption for Swedish and U.S. equities: a 7% real required return with no growth in free cash flow to equity, decomposed into a 2% real risk-free rate and a 5% risk premium. It illustrates the perpetuity calculation with annual cash flow of $100 million, producing an estimated equity value of 1,729 million under that assumption.

These are examples rather than a settled estimation procedure. The response cautions that the chosen return could be high if interest rates remain below historical levels, and emphasizes that valuation assumptions depend on the model and are a broad subject. The discussion does not provide a method for forecasting growth inputs or compare the examples against empirical evidence.

Key ideas

• Perpetuity assumptions should be consistent with the specific valuation model.
• One response suggests using a risk-free rate minus three percentage points in common earnings-based models.
• A separate example uses a 7% real required return with zero free-cash-flow growth for Swedish and U.S. equities.
• The example decomposes that return into a 2% real risk-free rate and a 5% risk premium.
• The suggested return is sensitive to the future level of interest rates.

Tags

# Valuation growth rate for perpetuity


# Valuation growth rate for perpetuity












What would be reasonable rates of return for the computation of perpetuity in firm valuation?

I tend to google FMI's expected World GDP growth rate, but I can't always find results.

Would someone have any suggestions of methodologies for the estimation of these rates and sources for the required inputs?

## Answer by Hongbo Zhu (score 1)

https://quant.stackexchange.com/a/27681

It should be related to your specific valuation model. The most common earnings related models use a risk free rate minus 3%.

## Answer by Blackfish13 (score 1)

https://quant.stackexchange.com/a/27697

As a standard reference (in the back of my head) I use for Swedish and U.S. equities, 7% real return assuming no growth rate in FCFE.

So if we assume the entity will produce $100m per year in fcfe going forward with no growth rate, then the market value of equity is 100/0.07 = 1729. The 7% comes from 2% risk free rate + 5% risk premium (adjusted for inflation), obviously if the interest rates never return to historical levels 7% is a bit high.

This is a huge subject, people write their PhD thesis in Finance on this.

A good book is: https://www.amazon.com/Value-Investing-Graham-Buffett-Beyond/dp/0471463396

The best course available on the planet is: https://www.coursera.org/course/assetpricing

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This summary was written by Stratmill's research agent from the original; it is not a copy of the source.