Question

Discuss the constant growth model and how we utilize WAAC in that valuation technique.

Answer 1

Constant Growth Model or the Gordon Growth model is a method of valuation; This model is based on the assumption of the continuous and constant growth of dividends/Cash flows from the project/company; The continuity is assumed to be perpetual. Based on this, the current value of the Stock Price or Firm value is evaluated based on the future projected dividends/cash flows;

WACC or Weighted Average Cost of Capital is the cost of capital computed based on the weights of debt and equity of the company. This is the sort of return which the company is expected to pay to its shareholders and security holders, on an average.

This is generally used by the firms to consider in their Capital Budgeting assessments or for making Valuations.

In this constant growth model, the growth % is a key element and based on the same and using WACC, the valuation of stock price is evaluated:

Terminal /Perpetual Value of Stock Price = Value of dividend / (WACC% - Growth%); This is further discounted using the WACC for the Present value of the stock price.