Stock Valuation and the Implied Growth Rate

Abstract

This paper presents a methodology of evaluating stocks based on their growth prospects, rather than the traditional relative valuation criteria. Briefly, the proposed approach considers prices as endogenous to the model and solves for the Implied Growth Rate (IGR) which satisfies the Terminal Value Multiple (TVM) in the Discounted Cash Flow model. In order to facilitate the implementation of the proposed approach by finance colleagues we have included some applications for the last ten years. The results are intriguing and demonstrate the effectiveness of the proposed valuation methodology as an investment criterion. Assuming a pre-established benchmark for IGR and TVM, one can determine whether a stock (or an Index of stocks) is fairly priced, under-priced or overpriced. For example, during the recent financial crisis period, the IGR was as low as 1.17% in the Spring of 2007, confirming the broad under-pricing of stocks. Using a five-year DCF approach with an expected return on the market portfolio of 12.3% and a risk-free rate of 3.7%, we find that the equilibrium long-term Implied Growth Rate in equities is around 6%. Obviously, a standard ten-year DCF approach would imply a smaller IGR. Using the Mehra and Prescott methodology (1985) we provide evidence that the long-term IGR should be around 4%.