Financial Education

Yesterday I looked at Rockwell Automation using a two-stage H-model, and came up with a valuation that was significantly higher than the current market price. I noted that the recent growth rate that I started with was much higher than the 14% consensus 5-year growth estimate. But why stop at just two growth stages?

Today I take the consensus at its word, and assume Rockwell can grow its current dividend of $1.16 at 14% for the next five years. The present value of those dividends is presented below.

At the end of that time, the growth will slow at a linear rate for 10 years to a terminal growth rate of 7% (the long-term S&P 500 average). The investor still has a 10% required return. That terminal value in five years can be estimated using the two-stage H model as (1.96 * 1.07)/(0.10 – 0.07) + ($1.96 * 5 * (0.14 – 0.07))/(0.10 – 0.07) or $69.90 + $22.86 or $92.76. That will be the assumed value in five years, so it must be discounted back to the present value at 10%. The present value is thus $92.76/1.10^5 or $57.60.

Adding the present value of the terminal value to the present value of the dividends yields $57.60 + $5.67 = $63.27, which is reasonably close to the current share price of $69.00. This suggests that the assumptions being made in this model – 14% growth for the next five years, growth slowing at a linear pace for another 10 years to a final and perpetual growth rate of 7% and a required return of 10% – might be fairly close to what the average investor (as represented by the market price) expects.

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

See also:

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

Multi-Stage Dividend Discount Models

Using the Market Price to Calculate Implicit Return in a Multi-Stage Dividend Discount Model

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

The Gordon Growth Model