Constant Growth Rate

The Constant Growth Rate (often abbreviated as 'g') is a crucial assumption in several financial models used to estimate a company's value. It represents the perpetual, steady rate at which a company's earnings or dividends are expected to grow into the indefinite future. While the idea of a company growing at the exact same rate forever might seem like a financial fairy tale, this concept is an elegant mathematical shortcut. It's most famously used in the Gordon Growth Model, a popular version of the Dividend Discount Model. The constant growth rate allows an investor to capture the value of all of a company's future cash flows beyond a specific forecast period (e.g., 5-10 years) in a single figure, known as the Terminal Value. For a value investor, 'g' isn't about gazing into a crystal ball; it's about making a disciplined and reasonable assumption to arrive at a conservative estimate of a business's Intrinsic Value.

The constant growth rate is the engine in some of the most fundamental valuation formulas. Its primary job is to help you figure out what a stable, mature company is worth today based on its future potential.

This model is the simplest way to see 'g' in action. It calculates a stock's intrinsic value with a straightforward formula: Intrinsic Value per Share = D1 / (k - g) Let's break that down with a simple analogy. Imagine you're buying a magical goose that lays golden eggs.

• D1 is the single golden egg you expect the goose to lay next year (the expected dividend per share).
• k is your discount rate or required rate of return. This is the annual return you demand for the risk of owning this particular goose instead of a safer one.
• g is our star: the constant rate at which the goose's egg-laying ability will grow each year, forever.

This formula tells you the maximum price you should pay for the goose today. It’s powerful but also extremely sensitive. A tiny tweak to 'g' or 'k' can dramatically change the valuation, which is why understanding the assumptions behind 'g' is so critical.

The word “constant” should immediately raise a skeptical eyebrow—a healthy reaction for any value investor. No company grows at a fixed rate forever. This part of the model is a simplification that comes with a very important rule.

A company cannot, in the long run, grow faster than the economy in which it operates. If it did, it would mathematically have to become larger than the entire economy, which is impossible. Therefore, a realistic and defensible constant growth rate 'g' for a mature company must be lower than the long-term growth rate of the economy. For stable, developed economies like the United States or the Eurozone, the long-term nominal Gross Domestic Product (GDP) growth rate has historically been in the 3-5% range. A prudent investor, therefore, will almost always use a 'g' that is below this level, often in the 2-3% range, which is similar to the long-term rate of inflation. Using a 'g' of 5% or higher is a red flag and suggests an overly optimistic (and likely wrong) valuation.

A reasonable 'g' is not just a guess; it's an educated estimate based on facts and logic. Here are four places to look for clues:

• Historical Growth: Look at the company’s track record. What has its average growth in revenue, earnings, and dividends been over the past 5-10 years? While the past doesn't predict the future, it provides essential context.
• Analyst Estimates: Check what professional analysts are forecasting for the company's long-term growth. Use this as another data point, but with a large dose of skepticism, as these estimates are often on the optimistic side.
• Economic and Industry Outlook: Consider the big picture. Is the company in a thriving industry with long-term tailwinds, or is it facing structural decline? A company selling typewriters won't have the same 'g' as one developing artificial intelligence software.
• The Sustainable Growth Rate: This is a fantastic, fundamentals-based approach. The formula is:
  • *g = Return on Equity (ROE) x (1 - Dividend Payout Ratio)**

In plain English, this means a company's growth is funded by the profits it reinvests back into the business (retained earnings). This formula calculates that growth rate by looking at how efficiently the company generates profit from its capital (ROE) and how much of that profit it plows back into the business. It’s a powerful check on your assumptions.

For a value investor, the constant growth rate is a tool to be used with humility and conservatism. The goal is not to pinpoint the exact future growth rate to the second decimal place—that's impossible. The goal is to be approximately right and to ensure you don't overpay. This is where the concept of a margin of safety becomes your best friend. Because 'g' is an estimate, you must insist on buying a stock for a price significantly below your calculated intrinsic value. That discount protects you if your growth assumptions turn out to be too high or if the future is simply less rosy than anticipated. By choosing a conservative 'g'—one that is well-reasoned and below the economy's long-term growth rate—you build the first layer of that safety margin directly into your valuation.