Error in Constant Growth Accounting Valuation Models

Abstract

The fundamental assumption of accounting-based valuation models is that in the long-run, the accounting component vanishes and dividends are recovered. Therefore, accounting policies do not matter. In the extensive literature on the subject, this assumption has not been questioned. The key proposition of this paper is that when these models are parameterized and constant growth is assumed, accounting policies do matter and impact the valuation. The valuation error is due to the non vanishing terminal value in the model. Thus, the characteristics of the accounting system that are implied by the assumption of constant growth violate the core assumption of both the residual income valuation model and the abnormal earnings growth model. There is one exception. When constant payout is assumed, the terminal value disappears.