An alternative formula for the constant growth model

Abstract

Purpose The traditional one-stage constant growth formula has two main underlying assumptions: a company will be able to maintain its competitive advantage for completed investments in perpetuity, and each year in the future, it will be able to generate new investment opportunities with the same competitive advantage, which will also remain in perpetuity. The purpose of this paper is to develop a model that limits the duration of the competitive advantage. Design/methodology/approach A new model is developed, and it is used to value a public company. Findings In this study, the author introduces an alternative formula considering the duration of the competitive advantage, imposing a restriction on the fact that extraordinary returns cannot be sustained forever, and also separates the part of the value explained by the current investments from the portion of value created by future investments. Originality/value The traditional one-stage constant growth model used to determine the continuing value of a company has limitations regarding the duration of the competitive advantage. The developed formula corrects the problem limiting the time extraordinary returns will remain over time.

Does duration of competitive advantage drive long-term returns in the stock market?

“…Hence, our contribution is to use a new methodology to develop a new indicator that does not need an econometric model to generate the expected returns. Besides, due to the fact that our indicator is based in the model of Forsyth (2019), it also includes the effect of companies' competitive advantage and provides a better estimate of the long-term expected returns at the aggregate level.…”

“…In the next section we explain the model developed by Forsyth (2019), a variant of the RIM that we will use to estimate our indicator called the IRE, but at the aggregate level. In the third section, we propose a method to model stock market returns with the IRE model at the aggregate level, while in the fourth and fifth sections we present the results and discuss them, respectively.…”

“…The model we use to estimate the IRE is based on Forsyth (2019). He developed the following equation that is an alternative formula, but mathematically identical, to the one-stage constant growth formula:…”

“…To incorporate different time restrictions into the duration of competitive advantage for current investments and for future investments, Forsyth (2019) converts the perpetuities of equation 1 to annuities and ends up with the following equation:…”