The Terminal Value and Inflation Controversy
Journal of Applied Corporate Finance (2012), 24(3), p. 101-107
Posted: 4 Oct 2012
Date Written: October 2, 2012
This journal recently published a debate between professors Gunther Friedl and Bernhard Schwetzler (hereafter “F&S”), on the one hand, and professors Michael Bradley and Gregg Jarrell (“B&J”), on the other hand. B&J initiated the first round of the debate by criticizing the constant growth valuation model, commonly known as the ”Constant Growth Model” or “Gordon Growth Model”, which was introduced by Myron Gordon and Eli Shapiro (“G&S”) in a 1956 paper and has long been widely used by corporate and investment practitioners. F&S replied to B&J with a defense of the original G&S formulation. In revisiting this debate, we find that the models B&J and F&S advocate are simply two versions of the G&S constant growth model, but with different assumptions about the amount of capital reinvestment required to sustain businesses indefinitely. By using a consistent set of assumptions about inflation and capital reinvestment, we resolve the dispute by showing that both models produce identical growth rates and estimates of value. At the same time, however, we recognize that both models (the G&S/F&S model and the B&J model) are appropriate for only a small subset of companies. The typical firm most likely operates somewhere between the two extremes.
Keywords: Terminal Value, Constant Growth Model, Valuation, Inflation
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