Understanding the Sum of Perpetuities Method for Valuing Stock Prices

Abstract

The Sum of Perpetuities Method (SPM) has been introduced as a method ofvaluing equity, and compared to the Gordon Growth Model (GGM). I point out somefeatures of these two valuation methods, and in particular I show that these two modelsmake different, sometimes implicit, assumptions regarding the firms' earningsreinvestment policies. I also show that firms following the reinvestment policiesunderlying the SPM grow slower, asymptotically, than firms following the reinvestmentpolicies underlying the GGM. I argue that the choice between using the SPM or GGMto value equity is equivalent to the choice of assumptions about firm behavior with respectto retaining and reinvesting earnings. I also introduce a hybrid model that encompassesboth the GGM and the SPM. (G10, G12)