Abstract
The most common valuation model is the dividend growth model. The growth rate is found by taking the product of the retention rate and the return on equity. What is less well understood are the basic assumptions of this model. In this paper, we demonstrate that the model makes strong assumptions regarding the financing mix of the firm. In addition, we discuss several methods suggested in the literature on estimating growth rates and analyze whether these approaches are consistent with the use of using a constant discount rate to evaluate the firm’s assets and equity. The literature has also suggested estimating growth rate by using the average percentage change method, compound-sum method, and/or regression methods. We demonstrate that the average percentage change is very sensitive to extreme observations. Moreover, on average, the regression method yields similar but somewhat smaller estimates of the growth rate compared to the compound-sum method. We also discussed the inferred method suggested by Gordon and Gordon (1997) to estimate the growth rate. Advantages, disadvantages, and the interrelationship among these estimation methods are also discussed in detail.
This chapter is a slightly revised version of Chapter 64 of Encyclopedia of Finance, 2nd Edition and Brick et al. (2014).
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Notes
- 1.
- 2.
Gordon and Shapiro’s (1956) model assume that dividends were paid continuously and hence P 0 = d 1/(r − g).
- 3.
Earnings in this model are defined using the cash-basis of accounting and not on an accrual basis.
- 4.
Generally, practioners define ROE as the ratio of the Net Income to the end of year Stockholders Equity. Here we are defining ROE as the ratio of the Net Income to the beginning of the year Stockholders Equity. Brick et al. (2012) demonstrate that the practitioner’s definition is one of the sources for the Bowman Paradox reported in the Organization Management literature.
- 5.
Increased in Assets is the net increase in assets. The total investment should also include the depreciation expense as can be seen in our examples delineated in Tables 46.1 and 46.2. But depreciation expense is also a source of funding. Hence, it is netted out in the relationship between increases in assets and retained earnings and new borrowings.
- 6.
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Brick, I.E., Chen, HY., Lee, CF. (2015). Alternative Methods for Estimating Firm’s Growth Rate. In: Lee, CF., Lee, J. (eds) Handbook of Financial Econometrics and Statistics. Springer, New York, NY. https://doi.org/10.1007/978-1-4614-7750-1_46
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