Phases of Growth and Valuation Models
Dividend discount models are based on the assumption of constant or linear growth. However, a mere look at the empirical data will prove that this is not the case in reality. Growth is almost never linear or constant. In fact, in strategic management, the concept of product or company life cycle is taught wherein there are multiple phases of growth. It would be an irony if the management gurus preached the philosophy of multiple stages of growth while building companies but used the assumption of constant growth while valuing them. Therefore it is important to understand the different stages of growth as well as the valuation model that needs to be used at each stage.
Phase 1: Initial Growth Phase:
This is stage when the company has just come into existence or it has discovered a new product, market or technology that will form the basis of extraordinary growth in forthcoming years. This phase is characterized by high earnings which are driven by high profit margins. Also, since the company is experiencing immense growth it will need to build up more capacity. This requires initial capital investment and the free cash flow generated by the firm is negative. Therefore the dividend payouts are close to zero even though the return being earned by equity shareholders is higher than their expected rate of return.
Appropriate Valuation Model: Since the firm is at a very early stage and growth is likely to rise and fall over the next few years, a three stage dividend discount model should be used to accurately account for these changes in the process of valuation.
Phase 2: Transition Phase:
The transition phase happens when the product, market or technology introduced by the company is no longer innovative. Customers have become used to the product and competition has also increased. Thus the company experiences a slightly lower level of growth during this phase.
This phase is characterized by earnings which are still above average but they are in a decline. This fall in earnings is caused by the reduced profit margins as a result of increased competition. However, at the same time the firm does not need massive influx of capital resources since the market is reaching closer to saturation and not much capital expenditure is required. Hence, the free cash flow from equity may be closer to zero or may even be slightly in the positive.
At this stage however, the firm may start paying off dividends since it is running out of opportunities to invest. This will also be characterized by a drop in the rate of return earned by equity shareholders.
Appropriate Valuation Model: Since not many changes are expected in the growth rate of the firm, the appropriate valuation model would be the two stage model. Dividends can be easily forecasted for a given horizon period and may stabilize over some time.
Phase 3: Maturity Phase
This is the stage when the industry has stabilized. The opportunities to grow are limited and consolidation takes place through mergers and acquisitions.
At the stage, most firms experience razor thin profit margins. However, the profits are stable and keep on flowing year after year in a very predictable manner. Also since there are almost no capital investments to be made, the firm experiences a massive positive cash flow to equity. Most of this cash flow is paid out to the shareholders in the form of dividends. However, the return on equity being provided to the shareholders may be very close to their required rate of return. Therefore, there are no abnormal returns being made at this stage.
Appropriate Valuation Model: At this stage, the simplistic assumptions of the Gordon growth model are more than sufficient to mimic the pattern of dividends that will be paid out by the firm. Hence, the valuation derived even from this simplistic elementary model is sufficient.
Companies may not necessarily go through all of these stages in the order mentioned. For instance, they may find new and new products to keep themselves in the growth stage for a longer time period. Consider the case of Apple which first introduced the iPod, followed by the iPhone and then the iPad to keep itself in the growth stage longer than any analyst had expected.
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