The perpetual growth model and the cost of computational efficiency

Abstract

The constant growth model (Gordon, 1962) plays an important role in the stock selection process for individual investors, in part, because of its computational simplicity. However, value estimates from the model can be highly dependent on cash flows to be received in the distant future. If future events might constrain a firm’s growth or lead to its demise, the unadjusted Gordon model can substantially overstate value. Because the model is less likely to misstate value for low-growth, high-payout firms, the ironic implication is that the model is most useful when its ability to value growth is needed least.