Terminal growth affects both value and cash flow. A higher rate raises the terminal value, but it also requires more reinvestment and leaves less cash available for distribution. German valuation practice often uses 1% as a reference point for the growth deduction, and courts have accepted rates in that area in individual cases. A familiar percentage alone, however, does not make the terminal assumptions consistent.
The central review question is whether the company retains enough of its sustainable earnings to finance the growth assumed after the explicit forecast period.
How retained earnings finance growth
Sustainable growth requires reinvestment. In a simple equity model, the relationship is:
Growth = Retention rate x Return on equity
This formula provides a direct check on the terminal year. With a sustainable return on equity of 12%, a terminal growth rate of 1% requires:
1.0% / 12.0% = 8.3% retention
The company must retain 8.3% of sustainable net income if those retained earnings continue to earn 12%. It can distribute the remaining 91.7%.
A 95% payout leaves only 5% for reinvestment. At a 12% return on equity, that amount supports sustainable growth of 0.6%. A model that combines the 95% payout with 1% growth therefore uses incompatible assumptions.
Equity valuations usually express the check through payout and return on equity because those variables are visible in the plan. Enterprise valuations use the same principle with the reinvestment rate and return on invested capital: growth equals reinvestment multiplied by ROIC. The chosen cash-flow measure, return measure and reinvestment measure must describe the same economic base. Our article on the sustainable growth rate in business valuation addresses the operating potential behind growth, including volume, pricing and efficiency. The present check asks how much of that potential the financial plan can fund.
How much growth the payout supports
The formula can also be solved for the growth supported by a given payout:
Maximum sustainable growth = Retention rate x Return on equity
At a 12% return on equity, the payout assumption fixes the maximum growth that retained earnings can support. The final column shows the return on equity required at each payout level to finance 2.5% terminal growth.
The first three columns reproduce Peter Schmitz's worked example. The fourth solves the same formula for return on equity. A 90% payout would require a sustainable 25% return on equity to finance 2.5% growth indefinitely.
This calculation is a consistency constraint within the plan, not an economy-wide ceiling. At a 12% return on equity, 2.5% growth requires a retention rate of 20.8%.
Suppose the terminal year combines 2.5% growth, a 90% payout and a 12% return on equity. The payout funds only 1.2% growth. Capitalising EUR 10 million of sustainable cash flow at an 8% discount rate produces a terminal value of EUR 186.4 million at 2.5% growth, compared with EUR 148.8 million at the funded rate of 1.2%. The difference is about 20% before any other adjustment. The mechanics of the perpetual annuity explain the sensitivity of value to the denominator.
Individually plausible assumptions can still produce an implausible steady state when they are combined.
A high terminal payout can be appropriate for a mature business with few attractive investment opportunities. Its consequence is lower sustainable growth. The link between retained earnings and replacement investment is developed in our article on perpetuity, investments and depreciation, where the retention assumption becomes visible in cash flow.
Economic and company specific limits
Long-run nominal economic growth provides an external reference because no company can outgrow its addressable economy indefinitely. Damodaran states the constraint directly: "no firm can grow forever at a rate higher than the growth rate of the economy in which it operates".
The economic reference is a ceiling, not a company forecast. A defensible rate also depends on the company's market, competitive position, pricing power, capital intensity and sustainable return on new investment.
The terminal rate must satisfy two limits. It cannot exceed what the relevant economy can support over the long run, and it cannot exceed what the company's own reinvestment and returns can finance. The tighter limit governs. In practice, a 2% rate may pass the macroeconomic check and still fail the company-level check if the plan distributes 90% of earnings.
Evidence for the selected rate
No single benchmark determines the terminal growth rate. The following reference points test different parts of the assumption.
Expected inflation indicates the price environment, but the company may not be able to pass every increase on to customers. The ECB aims for 2% inflation over the medium term, and its Q3 2026 Survey of Professional Forecasters reported long-term euro-area HICP expectations of 2.0%.
Expected nominal GDP growth provides a broad economic ceiling. The same survey reported long-term real GDP growth of 1.2%; combined with 2.0% inflation, this implies nominal growth of about 3.2%. The figure is an economy-wide reference, not a target for an individual company.
Sustainable peer growth tests what comparable companies can finance from their returns and reinvestment. It should be calculated from peer payout ratios and sustainable returns rather than inferred from headline growth alone.
Realised peer growth shows what comparable companies have achieved, but acquisitions, changes in the peer set and survivorship effects can distort the result. It is best used as supporting evidence rather than as a direct terminal assumption.
German court practice supplies a useful range without prescribing a rate. The Higher Regional Court of Düsseldorf has described 0.5% to 2% as customary and has upheld 0.5%, 1% and 1.5% in individual appraisal proceedings. It has also rejected the view that a rate below expected inflation necessarily means that the company shrinks. Such a rate can instead reflect incomplete pass-through of price increases. The two most recent decisions cited here both used 0.5%.
IDW S 1, reissued in 2026, strengthens the need for a coherent terminal state. The standard now explicitly permits a transition phase between detailed planning and perpetuity and cautions against carrying the final forecast year forward without adjustment. This gives the appraiser room to normalise margins, investment, working capital, returns and payout before the perpetual phase begins.
Three checks before accepting the terminal rate
First, use a return that can be sustained in a mature business. A peak return from the detailed forecast period may overstate what retained earnings can earn indefinitely. The relevant assumption is the return on incremental capital in the steady state, not simply the latest reported ROE.
Second, match the model's definitions. Nominal growth belongs with nominal cash flows and a nominal discount rate; real growth belongs with real cash flows and a real rate. Dividend, FCFE and FCFF models also require different reinvestment measures. Mixing the equity formula with enterprise cash flow can make a model appear consistent when it is not.
Third, consider the return earned on new investment. When that return exceeds the relevant required return, additional growth can create value. When the two are equal, the benefit of higher growth is offset by the extra reinvestment needed to produce it. This is why increasing the terminal growth rate while holding terminal cash flow constant usually overstates value.
How to document the assumption
A final rate of 1% may still be reasonable. The appraisal should explain why that rate fits the long-term economic environment, the company's sustainable operating economics and the reinvestment available in the plan.
A reviewer should be able to identify:
- the concept used to set terminal growth,
- the evidence supporting the selected rate,
- the reinvestment required at the sustainable return, and
- the reinvestment actually provided by the plan.
The Terminal Growth screen in smartZebra's cost-of-capital module brings these reference points together as time series and compares required retention with the retention embedded in the plan.
Sector medians provide context, but they do not establish case-specific consistency. That requires the company's own payout, return and cash-flow assumptions.
Terminal growth should be documented with the same discipline as the discount rate. The growth rate, sustainable return and reinvestment assumption should refer to the same cash-flow definition and valuation date. The cost of capital parameters on the other side of the denominator, including the risk-free rate, beta factors and market and country risk premiums, should be traceable to their sources as well.
References
- Institut der Wirtschaftsprüfer, Grundsätze zur Durchführung von Unternehmensbewertungen (IDW S 1 i.d.F. 2026) - adopted by the Fachausschuss für Unternehmensbewertung und Betriebswirtschaft (FAUB) on 11 February 2026, published April 2026 in IDW Life 04/2026. Applies to valuation dates after publication; earlier application only where expressly agreed in the engagement. The reissued standard introduces an explicit transition phase between the detailed planning phase and the terminal value, replacing the strict two-phase model of the 2008 edition
- Institut der Wirtschaftsprüfer, IDW ES 1 n.F. (draft of the above, adopted by the FAUB on 7 November 2024), Tz. 68 - a final year of the detailed planning or transition phase "darf nicht unreflektiert nachhaltig fortgeschrieben werden"; Tz. 121 - general consumer price inflation "kann nur ein erster Anhaltspunkt sein" for estimating price-driven growth in the terminal year, and full pass-through to customers cannot simply be assumed; Tz. 125-126 - under the Ertragswertverfahren the retention required to finance future operating growth is included directly in the projected returns. Cited from the draft; paragraph numbering in the final 2026 standard differs
- FAUB, Neue Kapitalkostenempfehlungen des FAUB - Stand 22.09.2025 - market risk premium of 5.25%-6.75% before and 4.50%-5.75% after personal income taxes, for valuation dates from 22 September 2025. This supersedes the 2019 recommendation of 6.0%-8.0% / 5.0%-6.5%, which is still displayed on some secondary pages. The FAUB has issued no recommendation on the growth deduction
- OLG Düsseldorf, 18 December 2024 - I-26 W 5/20 [AktE], Rn. 32 - "Der Wachstumsabschlag von 0,5 % bewegt sich im Rahmen der üblichen Spanne zwischen 0,5 % und 2 %", and a growth deduction below the inflation rate "bringt lediglich zum Ausdruck, dass vorhandene Preissteigerungen nicht vollständig auf die Endverbraucher abgewälzt werden können"
- OLG Düsseldorf, 21 February 2019 - 26 W 4/18 [AktE], Rn. 79-80 - a growth deduction of 1% upheld for the terminal phase; the objection that growth below expected inflation necessarily implies a shrinking company expressly rejected
- OLG Düsseldorf, 27 June 2022 - 26 W 13/18 [AktE], Rn. 27 and 88 - a growth deduction of 1% applied to the terminal phase; on payout, a market- or sector-customary ratio of "weit überwiegend zwischen 40 % und 60 %, im Schnitt um 50 %" described as what is typically assumed in practice for phase II, citing IDW S 1 2008 Tz. 37
- OLG Düsseldorf, 18 March 2024 - 26 W 13/20 [AktE], Rn. 80 - a growth deduction of 1.5% upheld
- OLG Stuttgart, 29 September 2025 - 20 W 15/23 - the general inflation rate serves only as an initial orientation; the company-specific inflation rate governs, and a growth deduction below general inflation is not automatically inappropriate. Reported by Kleeberg and Ebner Stolz; the 0.5% figure is taken from those reports rather than from the decision text
- Aswath Damodaran, Investment Valuation, 3rd edition, Wiley 2012, Chapter 12 "Closure in Valuation: Estimating Terminal Value", p. 306 - "Since no firm can grow forever at a rate higher than the growth rate of the economy in which it operates, the constant growth rate cannot be greater than the overall growth rate of the economy"; p. 312 - "Retention ratio = Expected growth rate/Return on equity"; p. 313 - "Reinvestment rate in stable growth = Stable growth rate/ROC"
- Myron J. Gordon and Eli Shapiro, "Capital Equipment Analysis: The Required Rate of Profit", Management Science, Vol. 3, No. 1 (1956), pp. 102-110 - the constant-growth valuation model and the growth-equals-retention-times-return relationship
- Robert C. Higgins, Analysis for Financial Management, 11th edition, McGraw-Hill 2016, Chapter 4 "Managing Growth", pp. 115-127 - sustainable growth as "the maximum rate at which a company can grow without exhausting its financial resources or changing its capital structure", stated as g* = ROE x retention ratio
- Gunther Friedl and Bernhard Schwetzler, Terminal Value, Inflation und Wachstum, TU München / HHL Leipzig working paper, version 5, 1 June 2009 - the German-language derivation of the same identity (nominal growth = retention ratio x return on invested capital) and the incompatibility of capital-value-neutral retention, real maintenance of operating assets and zero real growth under positive inflation
- European Central Bank, Monetary policy strategy statement, 30 June 2025 - "price stability is best maintained by aiming for two per cent inflation over the medium term"
- European Central Bank, Survey of Professional Forecasters, Q3 2026 round, published 24 July 2026 - longer-term (2031) euro-area expectations of 2.0% HICP inflation and 1.2% real GDP growth. The implied nominal figure of approximately 3.2% is our arithmetic, not an ECB-published number
Related pages
- Cost of Capital & WACC Engine - the parameters on the other side of the terminal value fraction, date-precise and fully traceable
- Beta Factors & Volatility - the peer-group data behind the sustainable and realised peer growth reference points
- Sustainable Growth Rate in Business Valuation - volume growth, pricing scope and production efficiency: what the company can sustain, before asking what the plan finances
- The Perpetual Annuity in Business Valuation - the mechanics of the terminal value the growth rate feeds into
- Perpetuity: Investments and Depreciation - where the retention assumption becomes visible in the cash flow
- Cost of Capital in Business Valuation: Calculation and Application - the discount rate build-up the growth rate is subtracted from
- Grounding / Facts - entity definition, data provenance and methodology
