BUS202: Principles of Finance

Valuations rely heavily on the expected growth rate of a company; past growth rate of sales and income provide insight into future growth.

TERM

• Gordon Growth Model

  Gordon Growth Model is also called the dividend discount model (DDM), which is a way of valuing a company based on the theory that a stock is worth the discounted sum of all of its future dividend payments.

Growth Rate

Valuations rely very heavily on the expected growth rate of a company. One must look at the historical growth rate of both sales and income to get a feeling for the type of future growth expected. However, companies are constantly changing, as well as the economy, so solely using historical growth rates to predict the future is not an acceptable form of valuation. Instead, they are used as guidelines for what future growth could look like if similar circumstances are encountered by the company. Calculating the future growth rate requires personal investment research. This may take form in listening to the company's quarterly conference call or reading a press release or other another company article that discusses the company's growth guidance. However, although companies are in the best position to forecast their own growth, they are far from accurate. Unforeseen events could cause rapid changes in the economy and in the company's industry.

And for any valuation technique, it's important to look at a range of forecast values.

• For example, if the company being valued has been growing earnings between 5 and 10% each year for the last five years, but believes that it will grow 15 - 20% this year, a more conservative growth rate of 10 - 15% would be appropriate in valuations.
• Another example would be for a company that has been going through restructuring. They may have been growing earnings at 10 - 15% over the past several quarters / years because of cost cutting, but their sales growth could be only 0 - 5%. This would signal that their earnings growth will probably slow when the cost cutting has fully taken effect. Therefore, forecasting an earnings growth closer to the 0 - 5% rate would be more appropriate rather than the 15 - 20%. Nonetheless, the growth rate method of valuations relies heavily on gut feel to make a forecast. This is why analysts often make inaccurate forecasts. It is also why familiarity with a company is essential before making a forecast.
  
  

Sum of Perpetuities Method

The PEG ratio is a special case in the Sum of Perpetuities Method (SPM) equation. A generalized version of the Walter model (1956), SPM considers the effects of dividends, earnings growth, as well as the risk profile of a firm on a stock's value. Derived from the compound interest formula using the present value of a perpetuity equation, SPM is an alternative to the Gordon Growth Model. The variables are:

• P is the value of the stock or business
• E is a company's earnings
• G is the company's constant growth rate
• K is the company's risk adjusted discount rate
• D is the company's dividend payment

$P=E∗GK2+DK$

Constant Growth Approximation

The Gordon model or Gordon's growth model is the best known of a class of discounted dividend models . It assumes that dividends will increase at a constant growth rate (less than the discount rate) forever. The valuation is given by the formula:

$P=D∗∑ ∞ \, i=1(1+g1+k)i = D∗1+gk−g$