Question

Explain the valuation of constant growtn and super normal growth of stock

Answer 1

The valuation of stock using constant growth is :

Po = D1/ Re - g

When the growth rate is constant, the value of the stock can be computed using the Gordon growth model, where the growth rate is constant.

For example, if the dividend just paid is $1.4, the growth rate is 4%. the required return on equity is 8%. The present value of stock is :

P0 = $1.4* 1.04/ 0.08 - 0,04

= $36.4

When the growth rate is super-normal, that  is the growth rate increases for a certain percentage for a certain number of years and then it changes again for a certain number of years till it reaches a constant growth which is the sustainable growth rate.

So, the price can be computed as :

Suppose D0 = $1.45

The growth rate is 4% for 3 years , 5 percent for 2 years and the constant growth rate is 2%.The required rate of return is 4%.

Po = D1/ 1.04 + D2/1.04^2 + D3/1.04^3 + D4/1.04^4 + D5/1.04^5 + D6/ 0.04 - 0.02

= $1.4935/1.04 + $1.5532/1.04 + $1.6154/1.04^3 + 1.6961/1.04^4 + 1.7809/1.04^5 + 1.8166/ 0.02/1.04^5

So, after solving the above equation we can get the price of the stock when the growth rate is super normal and not a constant growth rate.

= $81.87

So, the value of the stock when the growth rate is super normal is $81.87.