Valuing Stocks That Have a Nonconstant Growth Rate
by MaestriFor many companies, it is inappropriate to assume that dividends will grow at a constant rate. Firms typically go through life cycles. During the early part of their lives, their growth is much faster than that of the economy as a whole; then they match the economy’s growth; and finally their growth is slower than that of the economy.11 Automobile manufacturers in the 1920s, computer software firms such as Microsoft in
the 1990s, and Internet firms such as AOL in the 2000s are examples of firms in the early part of the cycle; these firms are called supernormal, or nonconstant, growth firms. Figure 5-2 illustrates nonconstant growth and also compares it with normal growth, zero growth, and negative growth.12
In the figure, the dividends of the supernormal growth firm are expected to grow at a 30 percent rate for three years, after which the growth rate is expected to fall to 8 percent, the assumed average for the economy. The value of this firm, like any other, is the present value of its expected future dividends as determined by Equation 5-1. When Dt is growing at a constant rate, we simplified Equation 5-1 to ˆP0 D1/(rs g). In the supernormal case, however, the expected growth rate is not a constant—it declines at the end of the period of supernormal growth.
Taken From : Five-Minute MBA – Corporate Finance
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