Sum of Perpetuities Method for Valuing Stock Prices

Abstract

The Gordon Growth Model is widely accepted in valuing growth stocks. Wederive an alternative constant growth model from the present value of a perpetuityequation given an assumption that investors discount a firm’s future retained earningsindependently from dividends. In a special case when a firm’s return on equity is equalto the discount rate, this alternative model is equivalent to the Gordon Growth Model.However we show using an empirical test that the alternative model correlatessignificantly more closely to actual stock prices when a firm’s return on equity differsfrom the discount rate. (G17)