Non-Constant Growth Stocks - YouTube

In this video we will discuss the non-constant growth stock model.

In our example we will look at a super normal growth stock that starts out at a high growth rate of 20%,

gradually decreasing to 15%,

and then to 6%.

This would be the situation in the tech industry when a company first starts and then is successful.

To figure out the value of the stock at a time Po right after Do was paid, we first need to figure out

various dividends and then the terminal value of the stock.

So if the dividend was just paid Do of $1,

and we want to know the value of the stock right after that dividend was paid,

we will first need to know the dividend D1 a year from then. That dividend will be Do of $1

times 1 plus the first high growth rate of 0.2 or

$1.2.

The dividend the year after that, D2 will then be the dividend of $1.2 times

1.15 or

$1.38.

The dividend in year 3 will be the $1.38 times one plus the constant growth of

0.06 or $1.46.

We then would need to know the present value of some of these dividends

The present value of the dividend D1 will be $1.2

divided by

c5 which is our required rate of return of

0.12 or $1.07.

The present value of the dividend in D2 is going to be $1.38

divided by

(1. 12)^2.

We will then need to know what the value of the stock would be right after this dividend D2 was paid,

which we will call P2. At that point, this becomes a constant growth stock,

so P2 will be D3 over Rs minus gc constant or

$1.46 over

0.12 - 0.06

which equals $24.38.

So that would be terminal value or the value of the stock right here after the dividend D2 was paid.

The present value of that will then be the $24.38 divided by

(1.12)^2 so

we have a dividend

D1, present value thereof,

followed by the present value of the dividend D2 and then the present value of the price of the stock

if it was sold right after the dividend D2 was paid.

Summing up these two dividends and the terminal value we get the value of the stock of $21.61.

Most of this value comes from the terminal value. If we take

$19.44 divided by $21.61 we get close to 90%.

The long term growth prospects of the stock are very important to its valuation.

It is also interesting to

examine how the dividend yield and the capital gains yield vary throughout the life of the growth of the stock.

The total required rate of return of a stock is the dividend yield plus the capital gains yield.

In our first year the dividend yield will be D1 of $1.2

divided by the price of the stock of $21.06 or

5.5%.

Therefore the capital gains yield has to equal

Rs minus D1/Po or

0.065.

In the final year when it becomes a constant growth stock

this equation becomes true and the growth rate becomes the capital gains yield;

therefore, the capital gains yield after his constant growth becomes 6% --

12% minus 6% leaves us 6%.

So over the life of the stock the capital gains yield starts out at 6.5%

and decreases to 6%. The dividend yield increases from 5.5% to 6%.

This would be consistent with a high growth rate company.

It starts out investing more money into the growth of the company and then over time as the company becomes more

stable it can afford to pay more money out in dividends.

I thank you for watching this video.