The DCF with LTG (Long term growth) is the most widespread version of the DCF methods. It computes the terminal value as the value of the free cash flow to equity a company will generate after the projected period, under the assumptions of survival and steady growth.
It assumes that a company will undergo two phases:
- An initial period characterized by fast, irregular growth, which needs to be explicitly modeled in the financial projections
- A second period – defined continuity – with constant expansion at a growth rate common to all companies in a given industry, called LTG rate
The value of the cash flows in continuity
In order to estimate the terminal value, the method assumes a company survives the first phase and then keeps sustainably growing. Thus, the free cash flow to equity of the first year after projections is the result of the year before (discounted by its survival rate) increased by the LTG rate.
The sum of all flows from this point in the future onward, discounted at the last projected year, is the terminal value. The following formula is applied to compute it:
Where Yn is the free cash flow to equity of the last projected year; SRn is the survival rate of the last projected year; LTG is the Long Term Growth rate; DR is the discount rate common to both DCF methods.