Stock Valuation

Valuations rely heavily on the expected growth rate of a company; the past growth rate of sales and income provide insight into future growth. A no-growth company would be expected to return high dividends under traditional finance theory. Ideally, the portion of the earnings not paid to investors is left for investment to provide for future earnings growth. By the end of this section, you will be able to explain how a stock is valued and describe the limitations of valuing a company with dividends that have a non-constant growth rate.

Valuing Nonconstant Growth Dividends

Limited high-growth approximation, implied growth models, and the imputed growth acceleration ratio are used to value nonconstant growth dividends.


LEARNING OBJECTIVE

  • Describe the limitations of valuing a company with dividends that have a nonconstant growth rate

KEY POINTS

    • Limited high-growth approximation: When a stock has a significantly higher growth rate than its peers, it is sometimes assumed that the earnings growth rate will be sustained for a short time (say, 5 years), and then the growth rate will revert to the mean.
    • Implied Growth Models: One can use the Gordon model or the limited high-growth period approximation model to impute an implied growth estimate.
    • Imputed growth acceleration ratio: Subsequently, one can divide this imputed growth estimate by recent historical growth rates.

TERMS

  • break-even

    Break-even (or break even) is the point of balance between making either a profit or a loss.

  • DCF models

    Valuation using discounted cash flows is a method for determining the current value of a company using future cash flows adjusted for time value. The future cash flow set is made up of the cash flows within the determined forecast period and a continuing value that represents the cash flow stream after the forecast period.


Limited High-growth Period Approximation

When a stock has a significantly higher growth rate than its peers, it is sometimes assumed that the earnings growth rate will be sustained for a short time (say, 5 years), and then the growth rate will revert to the mean. This is probably the most rigorous approximation that is practical.

While these DCF models are commonly used, the uncertainty in these values is hardly ever discussed. Note that the models diverge for and hence are extremely sensitive to the difference of dividend growth to discount factor. One might argue that an analyst can justify any value (and that would usually be one close to the current price supporting his call) by fine-tuning the growth/discount assumptions. DCF model can be used to calculate nonconstant growth dividends.


Implied Growth Models

One can use the Gordon model or the limited high-growth period approximation model to impute an implied growth estimate. To do this, one takes the average P/E and average growth for a comparison index, uses the current (or forward) P/E of the stock in question, and calculates what growth rate would be needed for the two valuation equations to be equal. This gives you an estimate of the "break-even" growth rate for the stock's current P/E ratio. (Note: we are using earnings not dividends here because dividend policies vary and may be influenced by many factors including tax treatment).


Imputed Growth Acceleration Ratio

Subsequently, one can divide this imputed growth estimate by recent historical growth rates. If the resulting ratio is greater than one, it implies that the stock would need to experience accelerated growth relative to its prior recent historical growth to justify its current P/E (higher values suggest potential overvaluation). If the resulting ratio is less than one, it implies that either the market expects growth to slow for this stock or that the stock could sustain its current P/E with lower than historical growth (lower values suggest potential undervaluation). Comparison of the IGAR across stocks in the same industry may give estimates of relative value. IGAR averages across an industry may give estimates of relative expected changes in industry growth (e.g. the market's imputed expectation that an industry is about to "take-off" or stagnate). Naturally, any differences in IGAR between stocks in the same industry may be due to differences in fundamentals, and would require further specific analysis.