Startup Tips

Is Your Startup Overvalued? Decode With Terminal Growth Rate

You've aced your product-market fit, your startup's in gear, and investors are circling. Now, how do you ascertain if your startup's valuation is correct? Enter Terminal Growth Rate. It sounds fancy, but what exactly is it, and why should you care?

What Will You Learn?

  • What Does It Mean? 
  • Why Is It Important For Your Business?
  • How Is It Calculated?

What Does It Mean?

Terminal Growth Rate, often abbreviated as TGR, is a crucial metric in financial modelling that represents a company's perpetual growth rate beyond a specific forecast period. In simpler terms, the TGR is that magic number that helps estimate how much your company's value can grow in the long run indefinitely after the initial high-growth phase. It's like a compass guiding investors towards your company's potential. 

Why Is It Important For Your Business?

  • Valuation Contributor - It's used in financial modelling to estimate the company's LTV and usually represents a significant contributor to the final valuation estimate.
  • Negotiation Power - A solid understanding of TGR equips you to negotiate better valuations during funding rounds. 
  • Strategic Planning - Knowing your TGR helps you plan for long-term growth, ensuring your company stays on track to achieve that magic number. 
  • Investor Confidence - A realistic TGR backed by sound reasoning builds trust with investors, making them more confident in your company's future.

Let’s understand using a simple example. Imagine valuing XYZ Inc., a phone company, using a DCF model. We can:

  • Forecast cash flow for 5 years, considering factors like phone sales and service revenue growth.
  • Estimate long-term growth beyond the initial 5 years because predicting specific cash flows can be tricky. Here, terminal growth rate comes in.
  • The TGR should be a steady, long-term growth rate the company can sustain. It's typically:some text
    • Lower than historical growth as past surges from new product launches might not be achievable forever.
    • In line with long-term GDP growth as it reflects the general economic trend, and XYZ’s growth can follow this trend.
    • At least equal to inflation so the company's cash flow doesn’t lose its purchasing power over time.
  • Let's say the analyst chooses 3% as the terminal growth rate. This implies XYZ's cash flow keeps growing at a steady 3% after the 5-year forecast, reflecting its ability to innovate, maintain brand strength, and expand sustainably.
  • This terminal growth rate will also significantly impact XYZ's future valuation.

Recur Club Insight

  • While a higher TGR could potentially translate to a higher valuation, finding the sweet spot is crucial. An overly ambitious number can paint an unrealistic picture, leading to overvaluation. 
  • Similarly, an excessively conservative TGR might undervalue your true potential. So, strike a realistic balance that attracts investors aligned with your vision.
  • Based on our example, the actual future growth of XYZ could be higher or lower than 3%. However, considering industry trends and XYZ’s competitive position can lead to an educated guess about the company's long-term growth potential.
  • Calculate the ratio alongside other assumptions like discount rate and forecast period to maintain consistency and not skew the final value because a coherent mix will ensure an accurate valuation.
  • Most importantly, regularly re-evaluate your Terminal Growth Rate based on market shifts, performance, and any adjustments to your financial projections. This ensures your valuation reflects the reality of your startup's journey.

How Is It Calculated?

One thing to keep in mind is that the TGR is an estimate, but here are some factors to consider when calculating it:

  • Macroeconomic indicators: Which market factors are likely to influence your business operations? 
  • Market Growth: How fast is your target market expanding? Can your company capture a significant share of this growth?
  • Historical Performance: Analyze your company's past growth trajectory. Is it sustainable or an outlier?
  • Industry Benchmarks: Research the average TGR for similar companies in your industry.
  • Competitive Landscape: How well-positioned is your company to outpace competitors in the long run?

All things considered, the Terminal Growth Rate isn't just a number for investors. It's a powerful tool to assess your growth strategy. By analyzing the factors above, you can identify areas to optimize and propel your startup towards that ever-important terminal growth.

Now that you understand TGR and its impact on your valuation, don't navigate this alone! Recur Club's capital consultants can be your sounding board. Get in touch to develop a compelling financial narrative that attracts investors and fuels your startup's growth journey. Tap below!

Shreya Mehra