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The Gordon growth model implicitly assumes that growth will be stable forever. However, many companies grow at a faster than normal rate before slowing to this stable condition. In such cases, investors can use a multi-stage dividend discount model wherein the Gordon growth model is used to estimate the value once the company matures, but where interim cash flows are estimated using some other method. One such method is the H-model.

The H-Model assumes that growth begins at some super-normal rate, then the growth rate declines in a linear fashion until it reaches the normal rate. Under the H-Model, Value = D0(1 + gt)/(r – gt) + D0H(gs – gt)/(r – gt).

The left side of the equation is the Gordon growth model discounted to the present from time t. gt is the growth rate at time t. gs is the current super growth rate and H is the half-life of the expected high growth period.

Consider a potential investment in Rockwell Automation (ROK). It pays a current dividend of $1.16 per share and ultimately its growth is likely to slow to the 7% historical average of the S&P 500.  However, its growth rate over the last five years has been 36%. Suppose an investor with a 10% required return believes Rockwell’s growth will slow from that pace to the 7% rate over the course of 10 years. How much would that investor be willing to pay for a share of ROK today?

Using the H-Model, Value = $1.16(1.07)/(0.10 – 0.07) +  (1.16 * 5)(0.36 – 0.10)/(0.10 – 0.07)

or Value =  $1.24/0.03 + ($5.80 * 0.26)/0.03 = $41.33 + $50.26 = $91.59. This compares with a current share price of $69.00, which could indicate one (or more) of several things:

• Rockwell Automation is undervalued
• The initial (super) growth rate estimate is too high
• The estimated high growth period is too long
• The market requires a higher return than 10%
• The terminal growth rate will be less than 7%

By  running the model, the investor can pinpoint where his or her own views may differ from those of the consensus. For example, the initial growth rate could be too high because analysts currently expect just 18% growth next year and a five-year average of 14% going forward.

For more information, see all articles on: Investing in Stocks, Valuation

See also:

Valuing a Non-Dividend Paying Stock Using the Dividend Discount Model

The Gordon Growth Model

Multi-Stage Dividend Discount Models

A Two Stage Dividend Discount Model With Constant First-Stage Growth

A Three Stage H-Model Dividend Discount Model