In the previous articles, we learned about how a dividend discount model can be use to value a stock using the future cash flows. However, in the constant growth model, we made an assumption that the dividends will grow at a constant rate. However, in reality this may not be the case. A firm may experience a period of very high growth and then after a few years, the growth rate may fall to a lower sustainable growth rate. In such a case we cannot apply the simple formula that we saw in the Gordon Growth Model that assumed a constant growth rate.
A stock with such characteristics can be valued by adding the present value of cash flows in the initial period of high growth and the present value of the stock after this high growth period assuming a constant growth rate.
Here, Pn is calculated using the Gordon Growth Model formula:
Let’s take a simple example to understand this:
Assume that a stock that pays dividends is expected to grow at a high rate of 15% per year for the first 3 years, after which it will grow at 6% per year.
The last dividends pay were $1, and the required rate of return in 8%.
Let’s see how multi-stage growth model can be used to value this stock.
D1 = 1*1.15 = $1.15
D2 = 1.15*1.15 = 1.3225
D3 = 1.3225*1.15 = 1.521
Note that after D3, the dividends are expected to grow at a constant growth rate of 6%. So, D3 will grow at a constant rate of 6%. We can use D3 and the constant growth rate to calculate P2, that is, the value of the stock at t=2.
P2 = D3/(k-g) = 1.521/(8% – 6%) = 76.05
The present value of the stock will now be the sum of D1, D2, and P2.
V0 = 1.15/(1.08) + 1.3225/(1.08)^2 + 76.05/(1.08)^2
Note that you could also calculate D1, D2, D3, and P3 and then take the present value of all these to arrive at the value of the stock. The answer will be the same.