When you have to value some sort of inflow with constant growth, we use the Gordon Growth Model. In the Gordon Growth model you grow the numerator by (1+g). Does this only apply to Dividends, FCFF, and FCFE?
I was doing the EOC questions for the Residual Income and came across number 14 about Dayton Manufactured Homes (pg. 519 Equity). This company has a growth rate of 10%. So when I came up with a residual value I did this calculation to arrive at the value of the residual income stream:
(RI(1+g))/(r-g)
When the answer basically says to do this:
RI/(r-g)
Is the reason we don’t grow RI is because it is RI and not like dividends and FCF?
Because we use a persistence factor with RI to determine its sustainability
The terminal value is included when we don’t know the exit value, and can be of multiple types (P/E with last EPS, P/B, H Model, DDM terminal, etc). It’s used once estimation is needed of the future growth rate from my experience. They will never give you 3 years of expected dividends and a terminal growth rate and expect the terminal growth value to be applied 1 year out, for example.
After doing some more EOC’s I think I’m just going to remember not to use the growth rate for residual income in the numerator when valuing the streams. Does that sound right to anyone?