Valuation Techniques: Discounted Cash Flow, Earnings Quality, Measures of Value Added, and Real Options

THE GORDON AND GORDON MODEL

The finite-growth model from Gordon and Gordon can be written as

(8.1)

Equation 8.1 uses the following definitions:

• The firm’s current stock price is Pt = 0. To interpret Pt = 0 as the stock price for a levered firm, one must assume that all new investments by the firm are financed with the same proportion of debt as the existing assets.
• The firm’s assets in place will produce a perpetual (after-tax) per share equity cash flow stream, called earnings, in the amount Et = 1. The first cash flow will be received in one year, at t = 1.
• Each year, the firm can reinvest a percentage ρ of its earnings in new projects. In each of the next τ years, the new investments will earn a return on equity of RN that exceeds the firm’s risk-adjusted required return on equity, k. In all subsequent years, new investments will earn a return on equity equal to the required return k. The remainder of the firm’s earnings each year will be paid as dividends. For example, the dividend to be paid at t = 1 is Dt = 1, which can be calculated as (1 − ρ)Et = 1. With these assumptions, earnings and dividends will grow at the annual rate ρRN over the time period τ and at the annual rate ρk in subsequent years. The entire dividend stream is discounted at the risk-adjusted rate k. This discount rate remains constant throughout time and is not affected by new investment.

Equation 8.1