Valuing Stocks That Have a Nonconstant Growth Rate (2)

by Maestri

Because Equation 5-2 requires a constant growth rate, we obviously cannot use it to value stocks that have nonconstant growth. However, assuming that a company currently enjoying supernormal growth will eventually slow down and become a constant growth stock, we can combine Equations 5-1 and 5-2 to form a new formula, Equation 5-5, for valuing it. First, we assume that the dividend will grow at a nonconstant rate (generally a relatively high rate) for N periods, after which it will grow at a constant rate, g. N is often called the terminal date, or horizon date.

We can use the constant growth formula, Equation 5-2, to determine what the stock’s horizon, or terminal, value will be N periods from today: To implement Equation 5-5, we go through the following three steps:

1. Find the PV of the dividends during the period of nonconstant growth.

2. Find the price of the stock at the end of the nonconstant growth period, at which point it has become a constant growth stock, and discount this price back to the present.
3. Add these two components to find the intrinsic value of the stock, ˆP0.

Taken From : Five-Minute MBA – Corporate Finance

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