Limited High-Growth Period Approximation for Stock Evaluation

There are three models commonly used for stock valuation explicitly based on growth. Those models are the average growth approximation, the constant growth approximation and the high-growth period approximation. Analysts use these models to determine whether a certain stock is worth the price it where it is currently listed. While none of the models are exact, they each offer insight into a stock's growth over time.

Average Growth Approximation

The average growth approximation is used to compare two stocks with similar earnings growth. It assumes that, all other things being equal, the stock that has a lower price to earnings ratio is preferable. This is a logical approach to stock valuation, but it goes one step further in attempting to estimate future price to earnings ratio, which is somewhat more speculative. Essentially, a target price to earnings (P/E) ratio is estimated for the stock. The analyst forecasts the expected performance of the stock based on its current ratios. Basically, using the current P/E and the target P/E, the analyst will estimate future earnings and earnings growth.

Constant Growth Approximation

This formula is often called the Gordon Model. It is a rather complicated mathematical expression of the simple belief that the dividends of a stock will increase at a constant growth rate forever. A constant growth stock is one that continually increases its dividends every year. Because of this constant growth, the stock may be overvalued. To better estimate the value of a constant growth stock, the discount dividend model may be applied. The discount dividend model (DDM) predicts dividends of a stock in the future then discounts them back to the present. This tells the analyst what a fair present price would be for the stock. If the current price is higher than that fair price, the stock is overvalued. If it is lower than the current price, the stock is considered a "value stock" and is ideal for purchase.

Limited High-Growth Period Approximation

This model is used for a stock that has seen a very rapid growth period in a short period of time and is significantly out-earning comparable stocks. Essentially, this model assumes that earnings power cannot be sustained forever. In fact, the model assumes it will not last more than five years at the most aggressive estimate. Using this model, an analyst can determine whether a stock is nearing the end of its high growth period or just beginning that period.

Weighted Stock Approximation on Limited High-Growth Stock

One way to estimate whether a stock is just picking up steam or fizzling out is weighting the growth over a period of time. The percentage growth in the most recent period of time, such as the last few months, is given a higher weight than the growth of the stock over the past six months. This gives the analyst an idea of whether growth rates have picked up in comparison to other high-growth stocks or slowed down in comparison. It is important to remember that each of these models is an approximation in name and in function, and outlying events do affect the accuracy of these models.