Posted in Finance, Accounting and Economics Terms, Total Reads: 648
Definition: Growth Approach
Growth Approach method is used in determining the value of a company. It assumes that the stock of a company is a discounted sum of all the future dividend payments and that the dividends grow at a constant rate for indefinite period. The stock value can then be calculated using the following formula:
When the constant growth rate becomes zero, then the stock value is simply the dividend per share divided by the required rate of return. We can find the cost of capital by simply modifying the formula as:
The problems with this approach is that the assumption of a constant growth rate being less than the required rate of return/ cost of capital can sometimes be wrong and can give negative values when the reverse happens. Also when the company doesn’t pay dividends (usually when it is growing), this model cannot be used and hence other techniques must be used instead.