Checklist Description
This checklist outlines the main uses of multistage dividend discount models and considers their advantages and disadvantages over standard dividend discount models.
Definition
Conventional dividend discount models attempt to value a company based on projections of future dividends discounted to reflect their present value. However, the main drawback of these models is their assumption that dividends will grow in perpetuity at a constant rate that can be determined at the time of the calculation. In practice this assumption is frequently unrealistic, with companies typically undergoing different stages of growth:
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High growth: Fast growth is typical early in the company’s development as it capitalizes on exciting opportunities in a new market segment or uses a new approach to aggressively gain a share of an existing market. With the overall market expanding, new clients may be relatively easy to attract, and revenues grow rapidly.
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Transition: The company’s initial growth spurt slows as the “market grab” period ends. Typically, the overall market may grow at a slower pace or the market may become more competitive, reducing scope for dynamic revenue growth.
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Maturity: Revenue growth slows as the market moves closer to saturation. New clients become more difficult to attract and companies may have to compete more aggressively on price or service to persuade new clients to switch from a competitor.
Recognizing the different phases of the growth of companies, multistage dividend models typically focus on forecast cash flows for the high-growth and transition stages. Only when the maturity phase is reached would this approach advocate using a constant dividend growth projection, often employing the Gordon growth model to assess a company’s longer-term value.
Advantages
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The multistage approach to companies’ development makes intuitive sense, recognizing and addressing the limitations of fixed-growth assumptions, making it more readily applicable to a wider range of nonmature companies.
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Multistage discount dividend models are versatile and flexible, readily facilitating amendments to their data inputs.
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The model’s flexibility extends to allowing us to test market assumptions by reversing the underlying calculation. For example, we can test the levels of growth at various time intervals implied by the prevailing share price.
Disadvantages
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Dividend discount models of all kinds put heavy reliance on the quality and accuracy of their data inputs. Despite their perceived advantages over fixed-growth techniques such as the Gordon growth model, multistage dividend growth models remain vulnerable to relatively minor inaccuracies in source data.
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Multistage models are particularly prone to errors in calculations resulting from poor cash flow estimates during the high-growth phase of a company’s development. At this relatively early stage, estimates of the constant dividend growth rate to be used in the maturity phase can be very difficult to make.
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For companies that are still in the early phases of growth, it can also be very difficult to accurately forecast the duration of the high-growth and subsequent transition stages. This may necessitate applying the models using a range of input parameters to help arrive at a more realistic valuation band.
Action Checklist
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As with all dividend discount models, it is imperative to establish the integrity and validity of the input data as far as is possible. The models are totally reliant on the numbers fed into them, making the resulting estimated valuations very sensitive to inaccurate inputs.
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Apply the multistage dividend discount model to the company you are interested in, and also to some of its industry competitors. Companies within the same sector could highlight apparent valuation anomalies or unjustified differences in their implied growth rates.
Dos and Don’ts
Do
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Realize that, despite their undoubted advantages over the fixed-growth approach, multistage discount models remain prone to inaccuracies from any one of a number of inputs.
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However, make maximum use of the model’s flexibility to test the market’s underlying assumptions. Use the model to ask questions, such as whether the implied growth phase timescales are too long or short, and whether the early growth rate forecasts are appropriate based on the present valuation.
Don’t
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Don’t use the models in isolation; rather, combine the technique with other methods of valuation.
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Don’t simply employ the model to test whether a stock is currently either under- or overvalued. Test your own assumptions on factors such as future growth rates and the duration of the growth cycle, performing “what if” analysis using variations on your initial input.
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