# Valuing a Stock With Supernormal Dividend Growth Rates

One of the most important skills an investor can learn is how to value a stock. It can be a big challenge though, especially when it comes to stocks that have supernormal growth rates. These are stocks that go through rapid growth for an extended period of time, say, for a year or more.

Many formulas in investing, though, are a little too simplistic given the constantly changing markets and evolving companies. Sometimes when you're presented with a growth company, you can't use a constant growth rate. In these cases, you need to know how to calculate value through both the company's early, high growth years, and its later, lower constant growth years. It can mean the difference between getting the right value or losing your shirt.

## Supernormal Growth Model

The supernormal growth model is most commonly seen in finance classes or more advanced investing certificate exams. It is based on discounting cash flows. The purpose of the supernormal growth model is to value a stock that is expected to have higher than normal growth in dividend payments for some period in the future. After this supernormal growth, the dividend is expected to go back to normal with constant growth.

To understand the supernormal growth model we will go through three steps:

1. Dividend discount model (no growth in dividend payments)
2. Dividend growth model with constant growth (Gordon Growth Model)
3. Dividend discount model with supernormal growth
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## Dividend Discount Model: No Dividend Payments Growth

Preferred equity will usually pay the stockholder a fixed dividend, unlike common shares. If you take this payment and find the present value of the perpetuity, you will find the implied value of the stock.

### Steps

1. Find the four high growth dividends.
2. Find the value of the constant growth dividends from the fifth dividend onward.
3. Discount each value.
4. Add up the total amount.

## Implementation

When doing a discount calculation, you are usually attempting to estimate the value of the future payments. Then you can compare this calculated intrinsic value to the market price to see if the stock is over or undervalued compared to your calculations. In theory, this technique would be used on growth companies expecting higher than normal growth, but the assumptions and expectations are hard to predict. Companies could not maintain a high growth rate over long periods of time. In a competitive market, new entrants and alternatives will compete for the same returns thus bringing the return on equity (ROE) down.

## The Bottom Line

Calculations using the supernormal growth model are difficult because of the assumptions involved, such as the required rate of return, growth or length of higher returns. If this is off it could drastically change the value of the shares. In most cases, such as tests or homework, these numbers will be given. But in the real world, we are left to calculate and estimate each of the metrics and evaluate the current asking price for shares. Supernormal growth is based on a simple idea, but can even give veteran investors trouble.

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