Investors need knowledge of stocks, their prices, and behavior in the marketplace to make good investment decisions. The Multistage Dividend Discount Model is a more sophisticated take on the Gordon Growth Model. As with many tools, the basic concept of determining the inherent value of a stock was first set out in the Gordon Growth Model and later refined by the Multistage Dividend Discount Model.
What Does the Gordon Model Tell Investors
To evaluate the fundamental value of a stock, it is helpful to account for its future dividends (that is, the earnings per share that the stock can achieve). This figure is a built-in value of a stock. With the Gordon Growth Model, a stock’s ability to grow over time is calculated at a steady rate. The Gordon Model offers a figure to the investor that represents the current value of a stock based on its future earnings (or dividends). The given dividend the stock pays out in one year is used to calculate what a stock will earn in perpetuity.
The limitation of the Gordon Growth Model, obviously, is that it assumes a constant rate of growth for a stock. While the model has value for a mature stock with low to moderate growth generally, and has been used for the wider market as well, it doesn’t work well with new stocks or more volatile industries.
Multistage Dividend Discount Model
Where the Multistage Dividend Discount Model improves on the Gordon Model is by adding changeable rates of growth to the calculation. In the Multistage Model, different growth rates are assumed for different periods in a stock’s history. Two-stage, three-stage, and H models are all variations of this basic concept.
In the two-stage model, a different rate of growth is projected for the beginning growth rate (either positive or negative), and then a second, long-term growth rate is assumed for perpetuity. The most significant flaw with this model is that it is assumed that a stock will quickly reach a steady growth rate.
The H model looks at stock movement in a different way. It assumes that a stock’s initial growth rate is strong, and eventually that rate slips over time into a steady pace. Again, it is assumed that this rate is constant, a significant flaw.
Under the three-stage model (applicable to most companies, given its flexibility), a stock experiences an initial growth period, followed by a second phase with a linear decline, and a third phase with finally, a stable growth rate.
Value of the Multistage Model for Investors
The biggest value the multistage model has over the Gordon Growth Model is that it takes into consideration the varying rates of a stock growth. This makes intuitive sense to any investor. Fixed-rate growth is more limiting, while using a Multistage Dividend Discount Model applies a more flexible approach. It allows for testing and readjustment of growth for different time intervals.
Where multistage models can be weak is in calculation errors during high-growth periods. Early growth rates can make it difficult to reliably determine later stable growth. It may also be challenging to determine the length of time stocks are likely to remain in various stages.
As with most models, the most important thing investors can do is have accurate data. In addition, by comparing both the stock in which they are interested and industry competitors, a more accurate picture can be gained. Most critically, investors should never use models in isolation. They are but one tool in a larger assessment process.