Alternative Methods for Estimating Firm’s Growth Rate: Update and Extension

The growth rate plays an important role in determining a firm’s asset and equity values. The premier model used to price equity is the basic dividend growth model of Gordon and Shapiro (1956). Nevertheless, the basic assumptions of the growth rate estimation model are less well understood. In this paper, we demonstrate that the model makes strong assumptions regarding the financing mix of the firm. In addition, we discuss various estimation methods of the firms’ growth rate. We demonstrate that the arithmetic average method is very sensitive to extreme observations, and the regression methods yield similar but somewhat smaller estimates of the growth rate compared to the compound-sum method. Interestingly, the ex post forecast shows that arithmetic average and compoundsum methods (continuous regression) yield the best (worst) performance with respect to estimating a firm’s future dividend growth rate. Firm characteristics, like size, book-to-market ratio, and systematic risk, have a significant influence on the forecast errors of dividend and sales growth rate estimation.