What effect does a lower growth rate have on the terminal value in a DCF analysis?

In a Discounted Cash Flow (DCF) analysis, the terminal value represents the present value of all future cash flows beyond a forecast period. It is a critical component because it often accounts for a significant portion of the total valuation.

When the growth rate is lowered, it typically results in a decrease in the terminal value. This is because the terminal value is often calculated using a perpetuity growth model, where the formula for terminal value is derived from the cash flow expected in the final forecast year divided by the discount rate minus the growth rate. If the growth rate is lowered, the denominator of this equation becomes smaller, which in turn causes the terminal value to decrease since you are dividing by a smaller number, assuming cash flows remain constant.

Thus, a lower growth rate affects the future income potential represented in the terminal value, leading to a reduced evaluation of that future cash flow, ultimately resulting in a lower terminal value.