The Average Growth Approximation for Stock Valuation

The average growth approximation used for stock valuation is an important assumption that has a significant impact on a stock’s estimated fair value. This approximation is based on multiple factors. Once it is made, you plug it into the dividend discount model to determine what a stock’s price should be. If the current trading price is below this number, the stock is said to be undervalued, and you should buy it. If the trading price is above the calculated price, it is overvalued and should be sold. It is important to recognize that is only one of the various ways to value a stock, and is not indicative of a good trading decision.

The Dividend Discount Model

The dividend discount model is based on the assumption that a stock is worth the discounted value of all of its future dividend payments. To use this model you need to know the current dividend rate, the required rate of return, and the average growth rate. This can be expressed as an equation:

  • Current Price = Dividend / (Required Rate of Return – Average Growth Rate)
  • or, P = D / (r – g).

This is a variation on the discounted cash flow model. The critical element is the idea that the value of an asset today is the sum of all of that asset’s future cask flows (dividends) discounted for inflation and / or the cost of capital. This is a widely accepted valuation model because it gives you a basis to estimate today’s value based on future events.

The Average Growth Assumption

In order for either the dividend discount model or the discounted cash flow model to work, you need to estimate future growth. You cannot know what a company’s specific dividends will be for the future. There are a variety of methods for estimating this growth rate. The first, and most basic, is to look at a company’s dividend history. Many companies strive to maintain a stable dividend policy. If this is the case, you can use the company’s historical growth rate. This assumes that the company will maintain this rate, which may be inaccurate. Amongst available options for making this estimation, this is a good choice for companies that are well established and have longer histories.

Companies that are earlier in the growth cycle, do not pay dividends, or have only a brief growth history, use a slightly different approach. For these companies, you can use an initial growth assumption, and then switch to an average growth rate that is last thereafter. This allows for the rapid growth phase before using the average growth rate for the longer-term, once the company reaches maturity.

In general, the average growth assumption within these models is very important. A small change in this rate can have a dramatic impact on the value for the current price that you calculate. As this is often the basis of trading decisions, you should pay careful attention to how the growth rate is selected.

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