Estimating the Growth Rate from Historical Data for Firms that Repurchase Stock

Abstract

One of the most important steps in a discounted cash flow valuation of a firm is the estimation of g, the long-term growth rate. This is commonly estimated by calculating g as the addition to retained earnings divided by beginning common equity. A serious problem can occur if the firm has participated in a stock buyback because buying back stock deflates the denominator. The financial statements record the historical value of the firm’s stock. Our purpose here is to present to students the distortion that can occur when firms repurchase their stock and a simple adjustment process to illustrate the reasonableness of a growth estimate.