## Info

q+gr

7 Unlike the stable growth model equation, this one can be used even if the expected growth rate exceeds the discount rate. While this makes the denominator negative, it will also result in a negative numerator, and the net effect will be positive. The only condition when it will not work if g=r, but the PV of dividends in that case will just be the product of the number of years of growth and dividends today since the growth and the discounting effects each year will cancel out.

A more general formulation would allow for growth during the high growth period, followed by a gradual reduction to stable growth over a transition period, as illustrated in figure 12.3:

Figure 12.3: High Growth followed by transition gn

High Growth ' Transition ' Stable Growth Period

High Growth Period

This model allows for growth rates and payout ratios to change gradually during the transition period.

Whatever path you devise to get your firm to stable growth, it is not just the growth rate that should change in stable growth. The other characteristics of the firm should also change to reflect the stable growth rates.

• The cost of equity should be more reflective of that of a mature firm. If it is being estimated using a beta, that beta should be closer to one in stable growth even though it can take on very high or very low values in high growth.

• The dividend payout ratio, which is usually low or zero for high growth firms, should increase as the firm becomes a stable growth firm. In fact, drawing on the fundamental growth equation from the last section, we can estimate the payout ratio in stable growth:

Dividend Payout Ratio = 1 - Retention Ratio = 1 - Expected growth rate/ ROE If we expect the stable growth rate to be 4% and the return on equity in stable growth to be 12%, the payout ratio in stable growth will be 66.67% (1- 4/12).

• The return on equity in stable growth, if used to estimate the payout ratio, should be also reflective of a stable growth firm. The most conservative estimate to make in stable g growth is that the return on equity will be equal to the cost of equity, thus denying the firm the possibility of excess returns in perpetuity. If this is too rigid a framework, you can assume that the return on equity will converge on an industry average in the stable growth phase.

If there is a transition period for growth, as in figure 12.3, the betas and payout ratios should adjust in the transition period, as the growth rate changes.

## Stocks and Shares Retirement Rescue

Get All The Support And Guidance You Need To Be A Success At Investing In Stocks And Shares. This Book Is One Of The Most Valuable Resources In The World When It Comes To

## Post a comment