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Nonconstant Growth Stock Valuation

Many firms enjoy periods of rapid growth. These periods may result from the introduction of a new product, a new technology, or an innovative marketing strategy. However, the period of rapid growth cannot continue indefinitely. Eventually, competitors will enter the market and catch up with the firm.

These firms cannot be valued properly using the Constant Growth Stock Valuation approach. This section presents a more general approach which allows for the dividends/growth rates during the period of rapid growth to be forecast. Then, it assumes that dividends will grow from that point on at a constant rate which reflects the long-term growth rate in the economy.

Stocks which are experiencing the above pattern of growth are called nonconstant, supernormal, or erratic growth stocks.

The value of a nonconstant growth stock can be determined using the following equation:

where

• P0 = the stock price at time 0,
• Dt = the expected dividend at time t,
• T = the number of years of nonconstant growth,
• gc = the long-term constant growth rate in dividends, and
• r = the required return on the stock, and
• gc < r.

 Nonconstant Growth Stock Valuation Example The current dividend on a stock is \$2 per share and investors require a rate of return of 12%. Dividends are expected to grow at a rate of 20% per year over the next three years and then at a rate of 5% per year from that point on. Find the price of the stock. Solution: There are 3 years of nonconstant growth, thus, T = 3. Before substituting into the formula given above it is necessary to calculate the expected dividends for years 1 through 4 using the provided growth rates.