What is a Supernormal Growth Stock
A supernormal growth stock is a security that experiences especially robust growth for a time, then eventually reverts back to normal levels of growth. During their supernormal growth stage, these stocks outperform the market significantly and provide investors with returns that are well above average. In order to be considered a supernormal growth stock, a stock’s price must continue to grow at an unusually fast pace for at least one year.
Breaking Down Supernormal Growth Stock
Supernormal growth stocks display unusually rapid growth for an extended period — a year, often longer — that generally outpaces any concurrent growth in the overall economy. A company’s period of abnormally rapid stock growth cannot be sustained indefinitely. Eventually, competitors will enter the market and catch up with the firm; then earnings will likely descend to a level that is more in line with the competition and the overall economy. In addition to the term “supernormal,” the idioms “nonconstant” and “erratic growth” may be applied to stocks that are experiencing this escalated growth pattern.
Supernormal growth is considered a regular part of an industry lifecycle, particularly when there is great demand for a new product. Thus, some startup companies naturally go through a supernormal growth phase. Many of the most successful companies in history have enjoyed supernormal growth at some point in their development. During their early years in particular, future blue-chip stocks often will appreciate at much higher levels than the broader market averages.
What Causes Supernormal Growth in Stocks?
Any number of factors may set off unusually rapid growth in a security: launching an exciting new product or technology; creating an innovative business model or marketing strategy; or initiating a much-needed service. A company also may achieve supernormal growth by possessing a patent, first-mover advantage, or another factor that provides a temporary lead in a specific marketplace. Further, an unusual growth spurt can occur because of situations that affect the economic environment — for example, if an engineering firm experiences a stock boom during unprecedented growth and demand in the construction industry. Another example of a trigger for supernormal growth could be when a business launches a successful new product that is based on artificial intelligence (AI) before AI technologies become mainstream.
The Challenge of Valuing Supernormal Growth Stocks
Stock valuation can be complicated enough, but placing a value on companies whose growth is accelerating rapidly can be tricky. Nonconstant, supernormal growth stocks cannot be valued in the same way as companies whose dividends are expected to grow at a constant rate — that is, in line with the economy — for the foreseeable future. For constant growth stocks, it is generally fine to stick with the Gordon Growth Model of valuation. The Gordon Growth Model — also known as the dividend discount model (DDM) — is a method for calculating the intrinsic value of a stock, exclusive of current market conditions. The model equates this value to the present value (PV) of a stock's future dividends.
Although the Gordon Growth Model is one of the simplest valuation formulas, it does not factor in any change in dividend growth over time. Hence, it is difficult to use this model accurately for supernormal stocks. In these cases, you need to know how to calculate value through the company's early, high-growth years, and its later, lower constant-growth years. In order to account for the slightly more volatile dividend activity of supernormal growth stocks, we can use a “two-stage” or "multi-stage” DDM instead. The basic two-stage model assumes a constant, extraordinary rate for the supernormal growth period followed by a constant, normal growth rate thereafter; and the difference in these two growth rates may be substantial.
A possible limitation of the two-stage model is that the transition between the initial abnormal growth period and the final steady-state growth period may be abrupt; and in some cases, a smoother transition to the mature-phase growth rate would be more realistic. Hence, academics and quantitative analysts have developed variations of the two-stage model in which growth begins at a high rate and declines in linear increments throughout the supernormal growth period until it reaches a normal rate at the end.
To read more about valuing supernormal stocks, please see our article, Valuing a Stock Wth Supernormal Dividend Growth Rates.