I am just trying to polish up my understanding of the dividend discount model when valuing companies. In essence, this entails:
1. Forecasting dividends from a company over say a 5 year period;
2. Estimating a terminal value of the company's shares at the end of the 5 year period
3. Discounting (1) and (2) back to a present value
My main interest is in part 2 of the above. In finance at uni (a long time ago) we were always advised that the terminal value for a share which was expected to last into perpetuity was calculated with reference to a long term cost of equity (k) and a terminal growth rate (g). We were advised that we shouldn't set "g" to be much higher than the long term GDP growth of an economy (usually 3% as a rule of thumb in Australia) as otherwise the terminal valuation would imply that the company would eventually grow larger than the whole economy, which was by definition impossible.
I am trying to think about "g" in the context of the above paragraph.
First, what does GDP measure? Is it total revenue or total profit in an economy? According to wikipedia it measures "the total dollar value of all goods and services produced over a specific time period". So, this implies to me that it is a total revenue measure.
If this is correct, then why can't a company have a terminal growth rate that is higher than long term GDP growth? Most companies have a level of fixed costs and many employ a degree of financial leverage, which implies that if revenue is expected to grow in perpetuity over the long term in line with GDP, then their net profit should grow faster than this in perpetuity. If dividends are tied to net profit in some way (ie a payout ratio), then the terminal growth rate for many companies' dividends can be expected to grow at a faster rate than GDP as well.
And so, in looking at the DDM and the terminal growth rate, if the above logic stands, I should be free to use a terminal growth rate in excess of expected long term GDP growth.
I am sure there are flaws in the above thought process, and would be very appreciative if people have views on the above.