Loading the player...

Many formulas in investing are a little too simplistic given the constantly changing markets and evolving companies. When presented with a growth company, sometimes you can't use a constant growth rate. In these cases you need to know how to calculate value through both the company's early, high growth years, and its later, lower constant growth years. It could mean the difference between getting the right value or losing your shirt.

The supernormal growth model is most commonly seen in finance classes or more advanced investing certificate exams. It is based on discounting cash flows, and the purpose of the supernormal growth model is to value a stock which is expected to have higher than normal growth in dividend payments for some period in the future. After this supernormal growth the dividend is expected to go back to a normal with a constant growth. (For a background reading, check out Digging Into The Dividend Discount Model.)
Tutorial: Discounted Cash Flow Analysis

To understand the supernormal growth model we will go through three steps.

1. Dividend discount model (no growth in dividend payments)

2. Dividend growth model with constant growth (Gordon Growth Model)

3. Dividend discount model with supernormal growth

Dividend Discount Model (No Growth in Dividend Payments)
Preferred equity will usually pay the stockholder a fixed dividend, unlike common shares. If you take this payment and find the present value of the perpetuity you will find the implied value of the stock.

For example, if ABC Company is set to pay a $1.45 dividend next period and the required rate of return is 9%, then the expected value of the stock using this method would be 1.45/0.09 = $16.11. Every dividend payment in the future was discounted back to the present and added together.

V = D1/(1+k) + D2/(1+k)2 + D3/(1+k)3 + ... + Dn/(1+k)n

Where:
V = the value
D1 = the dividend next period
k = the required rate of return

For example:

V = $1.45/(1.09) + $1.45/(1.09)2 + $1.45/(1.09)3 + … + $1.45/(1.09)n

V= $1.33 + 1.22 + 1.12 + . . .

V= $16.11

Because every dividend is the same we can reduce this equation down to: V= D/k

V=$1.45/0.09

V=$16.11

With common shares you will not have the predictability in the dividend distribution. To find the value of a common share, take the dividends you expect to receive during your holding period and discount it back to the present period. But there is one additional calculation: when you sell the common shares you will have a lump sum in the future which will have to be discounted back as well. We will use "P" to represent the future price of the shares when you sell them. Take this expected price (P) of the stock at the end of the holding period and discount it back at the discount rate. You can already see that there are more assumptions you need to make which increases the odds of miscalculating. (Explore arguments for and against company dividend policy, and learn how companies determine how much to pay out, read How And Why Do Companies Pay Dividends?)

For example, if you were thinking about holding a stock for three years and expected the price to be $35 after the third year, the expected dividend is $1.45 per year.

V= D1/(1+k) + D2/(1+k)2 + D3/(1+k)3 + P/(1+k)3

V = $1.45/1.09 + $1.45/1.092 + $1.45/1.093 + $35/1.093

Dividend Growth Model with Constant Growth (Gordon Growth Model)
Next let's assume there is a constant growth in the dividend. This would be best suited for evaluating larger stable dividend paying stocks. Look to the history of consistent dividend payments and predict the growth rate given the economy the industry and the company's policy on retained earnings.

Again we base the value on the present value of future cash flows:

V = D1/(1+k) + D2/(1+k)2+…..+Dn/(1+k)n

But we add a growth rate to each of the dividends (D1, D2, D3, etc.) In this example we will assume a 3% growth rate.

So D1 would be $1.45(1.03) = $1.49

D2 = $1.45(1.03)2 = $1.54

D3 = $1.45(1.03)3 = $1.58

This changes our original equation to :

V = D1(1.03)/(1+k) + D2(1.03)2/(1+k)2+…..+Dn(1.03)n/(1+k)n

V = $1.45(1.03)/(1.09) + $1.45(1.03)2/(1.09)2 + $1.45(1.03)3/(1.09)3 + … + $1.45(1.03)n/(1.09)n

V = $1.37 +$1.29 + $1.22 + ….

V = 24.89

This reduces down to: V = D1/k-g

Dividend Discount Model with Supernormal Growth
Now that we know how to calculate the value of a stock with a constantly growing dividend we can move on to a supernormal growth dividend.

One way to think about the dividend payments is in two parts (A and B). Part A has a higher growth dividend; Part B has a constant growth dividend. (For more, see How Dividends Work For Investors.)

A) Higher Growth
This part is pretty straight forward - calculate each dividend amount at the higher growth rate and discount it back to the present period. This takes care of the supernormal growth period; all that is left is the value of the dividend payments which will grow at a continuous rate.

B) Regular Growth
Still working with the last period of higher growth, calculate the value of the remaining dividends using the V = D1/(k-g) equation from the previous section. But D1 in this case would be next year's dividend, expected to be growing at the constant rate. Now discount back to the present value through four periods. A common mistake is discounting back five periods instead of four. But we use the fourth period because the valuation of the perpetuity of dividends is based on the end of year dividend in period four, which takes into account dividends in year five and on.

The values of all discounted dividend payments are added up to get the net present value. For example if you have a stock which pays a $1.45 dividend which is expected to grow at 15% for four years then at a constant 6% into the future. The discount rate is 11%.

Steps

1. Find the four high growth dividends.

2. Find the value of the constant growth dividends from the fifth dividend onward.

3. Discount each value.

4. Add up the total amount.

Period Dividend Calculation Amount Present Value
1 D1 $1.45 x 1.151 $1.67 $1.50
2 D2 $1.45 x 1.152 $1.92 $1.56
3 D3 $1.45 x 1.153 $2.21 $1.61
4 D4 $1.45 x 1.154 $2.54 $1.67
5 D5 $2.536 x 1.06 $2.69
$2.688 / (0.11 - 0.06) $53.76
$53.76 / 1.114 $35.42
NPV $41.76

Implementation
When doing a discount calculation you are usually attempting to estimate the value of the future payments. Then you can compare this calculated intrinsic value to the market price to see if the stock is over or undervalued compared to your calculations. In theory this technique would be used on growth companies expecting higher than normal growth, but the assumptions and expectations are hard to predict. Companies could not maintain a high growth rate over long periods of time. In a competitive market new entrants and alternatives will compete for the same returns thus bringing return on equity (ROE) down.

The Bottom Line
Calculations using the supernormal growth model are difficult because of the assumptions involved such as the required rate or return, growth or length of higher returns. If this is off, it could drastically change the value of the shares. In most cases, such as tests or homework, these numbers will be given, but in the real world we are left to calculate and estimate each of the metrics and evaluate the current asking price for shares. Supernormal growth is based on a simple idea but can even give veteran investors trouble. (For more, check out Taking Stock Of Discounted Cash Flow.)

Related Articles
  1. Markets

    Understanding the Supernormal Growth Model

    The supernormal growth model values a stock that’s expected to have higher than normal growth in dividend payments for some period in the future.
  2. Mutual Funds & ETFs

    The 3 Best American Funds for the Income Seeker in 2016

    Learn about American Funds' mutual fund offerings, their past performance compared to peers and three American funds to consider for income investors.
  3. Fundamental Analysis

    The 3 Best Investments When Bull Markets Slow Down

    Find out why no bull market lasts forever, and why investors should shift their assets away from growth and toward dividends when stocks slow down.
  4. Fundamental Analysis

    3 Long-Term Investing Strategies With Strong Track Records

    Learn why discipline and a statistically valid investment strategy can help an investor limit losses and beat the market over the long term.
  5. Investing Basics

    How And Why Do Companies Pay Dividends?

    The arguments for dividends include the idea that a dividend provides certainty about a company’s well being.
  6. Fundamental Analysis

    5 Must-Have Metrics For Value Investors

    Focusing on certain fundamental metrics is the best way for value investors to cash in gains. Here are the most important metrics to know.
  7. Mutual Funds & ETFs

    The 3 Best Vanguard Funds for Value Investors in 2016

    Find out which of Vanguard's value funds are the best for building a solid core-satellite value investing strategy for your portfolio.
  8. Stock Analysis

    Analyzing Altria's Return on Equity (ROE) (MO)

    Learn about Altria Group's return on equity (ROE) and analyze net profit margin, asset turnover and financial leverage to determine what is causing its high ROE.
  9. Investing Basics

    The Top 4 Income Investments for Retirees in 2016

    These four investment types should mitigate risk in 2016 for retirees seeking income.
  10. Mutual Funds & ETFs

    The 5 Best US Small Cap Value Index Mutual Funds

    Find out which index mutual funds do the best at investing in small-cap value stocks for higher potential returns at the lowest cost.
RELATED FAQS
  1. What is Fibonacci retracement, and where do the ratios that are used come from?

    Fibonacci retracement is a very popular tool among technical traders and is based on the key numbers identified by mathematician ... Read Full Answer >>
  2. What is the formula for calculating EBITDA?

    When analyzing financial fitness, corporate accountants and investors alike closely examine a company's financial statements ... Read Full Answer >>
  3. How do I calculate the P/E ratio of a company?

    The price-earnings ratio (P/E ratio) is a valuation measure that compares the level of stock prices to the level of corporate ... Read Full Answer >>
  4. How do you calculate return on equity (ROE)?

    Return on equity (ROE) is a ratio that provides investors insight into how efficiently a company (or more specifically, its ... Read Full Answer >>
  5. How do you calculate working capital?

    Working capital represents the difference between a firm’s current assets and current liabilities. The challenge can be determining ... Read Full Answer >>
  6. What is the formula for calculating the current ratio?

    The current ratio is a financial ratio that investors and analysts use to examine the liquidity of a company and its ability ... Read Full Answer >>
Hot Definitions
  1. Presidential Election Cycle (Theory)

    A theory developed by Yale Hirsch that states that U.S. stock markets are weakest in the year following the election of a ...
  2. Super Bowl Indicator

    An indicator based on the belief that a Super Bowl win for a team from the old AFL (AFC division) foretells a decline in ...
  3. Flight To Quality

    The action of investors moving their capital away from riskier investments to the safest possible investment vehicles. This ...
  4. Discouraged Worker

    A person who is eligible for employment and is able to work, but is currently unemployed and has not attempted to find employment ...
  5. Ponzimonium

    After Bernard Madoff's $65 billion Ponzi scheme was revealed, many new (smaller-scale) Ponzi schemers became exposed. Ponzimonium ...
  6. Quarterly Earnings Report

    A quarterly filing made by public companies to report their performance. Included in earnings reports are items such as net ...
Trading Center