Life and business are never clearcut. Unexpected twists and turns are bound to occur when you least expect them. However, if you’ve been following this blog for long enough, you know that the basic assumption of valuation is consistency.
Our discussion on the dividend discount model relied on the assumption that dividends will grow at a steady rate or that the rate of return investors require is stable over long periods of time. Anyone who’s seen a business grow over the course of decades can tell you it’s never a smooth ride. Businesses tend to grow in stages. Academics will point out that there are five key stages a new business must pass through. This is known as the business life cycle:
- Seed: This can also be understood as the ‘idea’ phase of the business.
- Startup: Defined by a small team, no profits, and huge potential.
- Rapid Growth: This stage is defined by increasing cash-flows, widening profit margins, increasing market-share, and better brand recognition.
- Maturity: A saturation phase where the business growth rates decline and stabilize.
- Decline or Exit: This is the only stage that isn’t necessary for a business. A lot of businesses decline as the competition increases or the prices are pushed down. Some are merged with others or bankrupted. However, most businesses can stay in the maturity phase forever.
How to Value a Company:
Of the five stages in the business life cycle, dividend stock investors only get to experience the last three. A company has moved beyond the seed and startup phases if it is publicly listed. This means that investors will only ever deal with companies that are growing rapidly. In a state of maturity, or gradually declining.
Let’s take a public company that fits neatly into each phase to analyze this further:
Tesla (Rapid Growth)
Tesla is the very definition of a growth company. It’s much smaller than its competitors in the automobile industry in terms of annual shipments, but it has plans to expand rapidly across the globe. Meanwhile, the company burns through an astounding amount of cash every year. Just last quarter the company burned through $970 million. At that rate, CEO Elon Musk admits, the company must raise cash soon to avoid crashing over the edge. However, the cash burn is helping the company launch its latest models everywhere from Hong Kong to Norway. Car shipments have been doubling every year.
Unlike Tesla’s volatile growth spurt, Apple has lived through its years of double-digit growth and massive cash burn. Sales for its flagship iPhone declined for the first time in its history last quarter. Overall sales are steady but Apple expects the growth rate to be in the low single digits for the foreseeable future. It’s a market-leader in a high-profit business, which means it creates an astounding amount of free cash every year and gives back a sizable chunk of it to investors. The fact that Warren Buffett is now one of the biggest investors in Apple is a clear sign the company has a steady future as a value-oriented tech company (similar to IBM).
Exxon Mobil (Gradual decline)
There’s no doubt the oil market is in gradual decline, so big companies will see their size reduced over the next decade. The biggest, perhaps, is Exxon Mobil. Earning last year were lower by 40%, revenue dropped 45%, while the company’s market capitalization has taken a severe beating. There are clear signs the company is on the brink of irreversible decline.
This begs the question – how do you value a company?
A growing company will either stabilize or decline after a while, so how can an investor value the present value of a potential buy today?
The answer lies is simple – if the company grows in stages, the dividend discount model will have to be applied in stages too. In other words, an expanded version of the dividend discount model would allow an investor to account for the multiple stages of growth. This is known as the ‘Multi-stage DDM model’.
The most common variations of the DDM are two-stage, three-stage, and H-models.
2-stage, as the name implies, considers the value of the company with two distinct stages of growth. There is an initial stage of rapid growth and a later stage of slower growth. If you add a stage in between where the growth rate is not too high or too low, you get the three-stage model.
The H-model, meanwhile, is an assumption that a fast growing company will see its growth rate decline at a reasonable phase. For example, if Tesla is growing 100% today and could be growing only 5% annually by 2050, it’s reasonable to assume the growth rate will decrease every year till then.
Here are the formulas for all three models:
Where, gs is the growth rate during the initial few years and gl is the long term growth rate. The long term growth rate will, undoubtedly, be lower than the short-term, rapid growth rate.
These three formulas may look complicated, but the good news is you don’t have to memorize them. You can easily get a financial service platform that calculates this for you. Try Calculator Pro or Wolfram Alpha to see what a particular stock is worth through multi-stage dividend discount models.
Discounted dividends over a period of time is, perhaps, the easiest way to value dividend-paying stocks. We’ve discussed the power of this model before. But the model has one crucial weakness – it assumes consistency. Companies and businesses are unpredictable and their dividends can be inconsistent. So there’s a need to adapt the model to take different stages of growth into account. With the formulas mentioned here you can estimate the growth rate for different companies at different stages to more accurately predict the value of the company today.