Question

An investor considers a stock that expects to have high growth over the next 5 years and then a constant growth rate thereafter. As a result, the stock follows the pattern of a two-stage valuation model. If the investor instead uses a constant growth model using the constant growth rate that the company expects after year 5, he/she:

Answer 1

Solution :-

If the investor ,instead of using high growth rate over the next 5 years, uses constant growth rate then he/ she will be following "Constant growth rate divident discount model" - Gordons growth model. Gordon assumes dividends grow by a specific percentage each year, and is usually denoted as g and the capitalisation rate is denoted by k.

The constant-growth model is often used to value stocks of mature companies that have increased the dividend steadily over the years. Although the annual increase is not always the same, the constant-growth model can be used to approximate an intrinsic value of the stock using the average of the dividend growth and projecting that average to future dividend increases.

Constant growth rate DDM Formula,

Intrinsic value = D1/ k-g

D1 = Next years dividend

k = Capitalisation rate

g = Dividend growth rate

​​​​​Whereas in the case of variable growth rate dividend discount model, different growth rates will be used for every year - an initial high rate of growth, a transition to slower growth, and lastly, a sustainable, steady rate of growth. In our question, its been mentioned as higher growth rate over the inital 5 years , which means its been in initial stage as per variable growth rate DDM.

​​​​​​​​Basically, the constant-growth rate model is extended, with each phase of growth calculated using the constant-growth method, but using 3 different growth rates of the 3 phases. The present values of each stage are added together to derive the intrinsic value of the stock.