Inflation and the Constant Growth Model – Reconciling the Literature

Abstract

We formulate a generalized constant growth valuation model incorporating inflation and capital maintenance. We find that in general there are two sources of growth: growth due to capital maintenance and growth due to net new investments. The generalized version of the constant growth model allows the reconciliation of the existing literature, particularly the works of Gordon and Shapiro (1956), Lally (1988), and Bradley and Jarrell (2008), which all employ particular definitions of capital maintenance. Evaluating the practical relevance of either model we find that each model is best suited for a very particular company set‐up, which does not necessarily correspond to the commonly observed business models. The generalized version of the constant growth valuation model, however, presents a flexible approach that is capable of capturing various conceptions of capital maintenance.