Stock Valuation (cont.) Week 3

Beyond the Gordon Growth Model The Gordon Growth model assumes a steady growth rate, g. In addition, it is required that the growth rate “g” must be less than the required return for equity, “k”. –If g>k, then the stock price would be “infinity”. What do we do if the g is not constant or is too high?

Changing Dividends If the growth rate in dividend is not constant, we will have to forecast and discount each dividend separately. If the growth rate is higher than the cost of capital, we will assume that the growth rate comes down in later years. –It is, in fact, unreasonable to assume that any company can grow faster than the US GDP nominal growth rate in the long run. As the current nominal GDP growth rate is about 6%, it is unlikely that any growth rate above this number is sustainable.

Multi-Stage Model A simple way to implement supernormal growth rates is to divide the model into two stages. First stage: Assume that the firm has a supernormal growth rate for a few years (say, 3- 5). Each dividend in these years can be discounted individually. Second stage: Assume that the long-term growth rate reduces to about 6%. We can now apply the Gordon Growth formula to get the price of the stock at the beginning of the second stage.

An Example Suppose a firm is expected to have supernormal growth rate of g 1 for 3 years, and then a normal growth rate of g 2 to perpetuity. The current dividend is D 0 The estimate of the price is then: P 0 =D 1 /(1+k) +D 2 /(1+k) 2 + D 3 /(1+k) 3 + [D 4 /(k-g 2 )]/(1+k) 3 D 1 =D 0 (1+g 1 ), D 2 =D 0 (1+g 1 ) 2, D 2 =D 0 (1+g 1 ) 3

Implementation of the Extended Model The main problem in implementation of this enhanced model is that one has to estimate the time period over which the firm will have supernormal growth rate. –You may use analyst’s forecasts to estimate the supernormal growth period.