What does the perpetuity growth method assume regarding free cash flows for terminal value calculation?

The perpetuity growth method assumes that free cash flows will grow at a stable rate indefinitely. This method is commonly used to calculate the terminal value in a Discounted Cash Flow (DCF) analysis, where it is essential to estimate the value of a company beyond the explicit forecast period.

By assuming a stable growth rate, the method acknowledges that, after a certain point, the business will continue to generate cash flows that increase at a consistent pace, reflecting a rational expectation about persistent growth in the company's operations, productivity, or market position. This assumption is fundamental because it allows analysts to derive a formula for calculating terminal value based on the final year's cash flow, extrapolated into the future with a fixed growth rate.

This growth rate should ideally be less than the overall economic growth to reflect sustainable growth rates that realistic businesses would encounter, thus ensuring that the terminal value provides a reasonable estimate in line with the long-term economic environment.