The question of how to allocate profits is linked to where a company is in its life cycle

One of the most important decisions management makes is how to allocate profits.

The decision of what to do with earnings is linked to where a company is in its life cycle.

The question of how to allocate profits is linked to where a company is in its life cycle.

1.  Development Stage

In the development stage, a company loses money as it develops products and establishes markets.

2.  Rapid Growth Stage.

The next stage would be rapid growth, in which a company is profitable but growing so fast that it may need to retain all earnings and also borrow funds or issue equity to finance this growth.

3.  Maturity and Decline

In later stages, maturity and decline, a company will continue to generate excess cash, and the best use of this cash may be allocating it to shareholders.

Valuing A Stock With Supernormal Dividend Growth Rates

by Peter Cherewyk 

The supernormal growth model is most commonly seen in finance classes or more advanced investing certificate exams. It is based on discounting cash flows, and the purpose of the supernormal growth model is to value a stock which 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 a normal with a constant growth. (For a background reading, check out Digging Into The Dividend Discount Model.)

Tutorial: Discounted Cash Flow Analysis

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

Dividend Discount Model (No Growth in Dividend Payments)
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.

For example, if ABC Company is set to pay a $1.45 dividend next period and the required rate of return is 9%, then the expected value of the stock using this method would be 1.45/0.09 = $16.11. Every dividend payment in the future was discounted back to the present and added together.

V = D1/(1+k) + D2/(1+k)2 + D3/(1+k)3 + ... + Dn/(1+k)n

Where:
V = the value
D₁ = the dividend next period
k = the required rate of return

For example:

V = $1.45/(1.09) + $1.45/(1.09)2 + $1.45/(1.09)3 + … + $1.45/(1.09)n V= $1.33 + 1.22 + 1.12 + . . . V= $16.11

Because every dividend is the same we can reduce this equation down to: V= D/k

V=$1.45/0.09

V=$16.11

With common shares you will not have the predictability in the dividend distribution. To find the value of a common share, take the dividends you expect to receive during your holding period and discount it back to the present period. But there is one additional calculation: when you sell the common shares you will have a lump sum in the future which will have to be discounted back as well. We will use "P" to represent the future price of the shares when you sell them. Take this expected price (P) of the stock at the end of the holding period and discount it back at the discount rate. You can already see that there are more assumptions you need to make which increases the odds of miscalculating. (Explore arguments for and against company dividend policy, and learn how companies determine how much to pay out, read How And Why Do Companies Pay Dividends?)

For example, if you were thinking about holding a stock for three years and expected the price to be $35 after the third year,  the expected dividend is $1.45 per year.

V= D1/(1+k) + D2/(1+k)2  + D3/(1+k)3 + P/(1+k)3 V = $1.45/1.09 + $1.45/1.092 + $1.45/1.093 +$35/1.093

Dividend Growth Model with Constant Growth (Gordon Growth Model)
Next let's assume there is a constant growth in the dividend. This would be best suited for evaluating larger stable dividend paying stocks. Look to the history of consistent dividend payments and predict the growth rate given the economy the industry and the company's policy on retained earnings.

Again we base the value on the present value of future cash flows:

V = D1/(1+k) + D2/(1+k)2+…..+Dn/(1+k)n

But we add a growth rate to each of the dividends (D₁, D₂, D₃, etc.) In this example we will assume a 3% growth rate.

So D₁ would be $1.45(1.03) = $1.49

D₂ = $1.45(1.03)² = $1.54

D₃ = $1.45(1.03)³ = $1.58

This changes our original equation to : 

V = D1(1.03)/(1+k) + D2(1.03)2/(1+k)2+…..+Dn(1.03)n/(1+k)n V = $1.45(1.03)/(1.09) + $1.45(1.03)2/(1.09)2 + $1.45(1.03)3/(1.09)3 + … + $1.45(1.03)n/(1.09)n V = $1.37 +$1.29 + $1.22 + …. V = 24.89

This reduces down to: V = D₁/k-g

Dividend Discount Model with Supernormal Growth
Now that we know how to calculate the value of a stock with a constantly growing dividend we can move on to a supernormal growth dividend.

One way to think about the dividend payments is in two parts (A and B). Part A has a higher growth dividend; Part B has a constant growth dividend. (For more, see How Dividends Work For Investors.)

A) Higher Growth
This part is pretty straight forward - calculate each dividend amount at the higher growth rate and discount it back to the present period. This takes care of the supernormal growth period; all that is left is the value of the dividend payments which will grow at a continuous rate.

B) Regular Growth
Still working with the last period of higher growth, calculate the value of the remaining dividends using the V = D₁/(k-g) equation from the previous section. But D₁ in this case would be next year's dividend, expected to be growing at the constant rate. Now discount back to the present value through four periods. A common mistake is discounting back five periods instead of four. But we use the fourth period because the valuation of the perpetuity of dividends is based on the end of year dividend in period four, which takes into account dividends in year five and on.

The values of all discounted dividend payments are added up to get the net present value. For example if you have a stock which pays a $1.45 dividend which is expected to grow at 15% for three years then at a constant 6% into the future. The discount rate is 12%.

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.

Period	Dividend	Calculation	Amount	Present Value
1	D1	$1.45 x 1.151	$1.67	$1.50
2	D2	$1.45 x 1.152	$1.92	$1.56
3	D3	$1.45 x 1.153	$2.21	$1.61
4	D4	$1.45 x 1.154	$2.54	$1.67
5	D5 …	$2.536 x 1.06	$2.69
		$2.688 / (0.11 - 0.06)	$53.76
		$53.76 / 1.114		$35.42
			NPV	$41.76

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 return on equity (ROE) down.

The Bottom LineCalculations using the supernormal growth model are difficult because of the assumptions involved such as the required rate or 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. (For more, check out Taking Stock Of Discounted Cash Flow.)

by Peter Cherewyk (Contact Author | Biography)

Peter Cherewyk has worked in the financial field for over 10 years. He completed his Bachelor of Commerce from the University of Alberta, and is currently working towards a Chartered Financial Analyst designation. He enjoys hockey and hiking and the opportunity to teach others.

Filed Under: Dividend, Fundamental Analysis, Stock Analysis, Stocks

http://www.investopedia.com/articles/fundamental-analysis/11/supernormal-growth-analysis.asp

What dictates dividend policy?

Management determines if it is going to distribute earnings in the form of a dividend or reinvest all earnings to further the business plan of the company.  The ratio of dividends paid out to investors versus the amount of earnings retained is called the payout ratio.  Changes in tax law and investor preference can influence decisions in the corporate boardroom regarding how much profit to retain or to pay out to investors in the form of dividends.  However, dividend increases often lag behind an increase in earnings because management will want to be certain that a new higher dividend payment will be sustainable going forward.

Looking back over market history, we can see that dividend policy and payouts have remained relatively steady and that any change in dividend yield has had a lot more to do with the change in stock prices than with changes to dividend policy made by corporate directors.  (Note:  You can 'price' your stocks by looking at historical dividend yields.)

Management is usually very reluctant to reduce dividends because a cut is often perceived as a sign of financial weakness.  Even during the Great Depression, companies were loath to cut dividends.  From 1929 to 1932, dividend yields soared because most companies maintained their dividends as stock prices collapsed in the crash.  But, as stock prices rose from 1933 to 1936, dividend yields fell - even though companies were actually increasing the dividends they paid.

This inverse relationship between dividend yield and price was really evident during the huge bull market run from 1982 to 1999.  Companies increased dividends steadily over the period, actually increasing dividends paid by almost 400 percent.  Yet the dividend yield collapsed to historic lows because stock prices increased by 1,500 per cent.

Some companies do run into trouble and cut or omit their dividend payments, but this is the exception rather than the rule. 

• The typical dividend-paying company not only maintains the dividend payout it establishes, but follows a policy of steadily increasing its dividend as earnings increase. 
• Some companies increase their dividend payments every quarter, some once per year, and others only as profits allow. 
• Some companies will even pay extra or special dividends if earnings have been quite good for a number of years.

Many established public companies pay cash dividends and have a dividend policy that is well known to their investors.  Some of them have been paying cash dividends for a very long time.

Twelve of the companies in the S&P 500 today started paying dividends more than a century ago.

S&P 500 Century Dividend Payers

Company ----  Cash Dividends Paid Each Year Since
Stanley Works ----1877
Consolidated Edison ---- 1885
Lilly (Eli) ---- 1885
Johnson Controls ---- 1887
Procter & Gamble ----1891
Coca-Cola Co ---- 1893
First Tennessee National ---- 1895
General Electric ---- 1899
PPG Industries ---- 1899
TECO Energy ---- 1900
Pfizer. Inc. ---- 1901
Chubb Corp ---- 1902
Bank of America ---- 1903

Business and Dividend Life Cycles

Business life cycles are most influenced by access to resources and capital. 

A company's success and development are also affected by a host of outside factors - competition from companies in the same industry, economic conditions, even changing consumer preferences.

There are 6 phases in a company's development that influence its dividend policy:

1. The Start-Up Phase:   In the start-up phase, someone invest cash for stock in the business to develop products, hire employees, pay for equipment, and rent space.  It is not unusual for a company to raise seed money from professional investors and enter the start-up phase with a hundred or more employees.  A small company needs to plow all profits back into growing and perfecting its business model to survive.

2.  The Early Growth Phase:  If the company launch is successful, it will enter the early growth phase.  As the demand for its products and services increases, sales and profits increase.  The company will need to reinvest all cash flow and profit to achieve competitive scale.

3.  The Late Stage Growth Phase:  In the late stage growth phase, the company continues to grow and may begin to pay a small dividend, usually 10 to 15% of earnings.  This is a clear signal to investors that the company has reached a level of stability in profits and cash flow necessary to support a dividend.

4.  The Expansion Phase:  If the company is well run, it will enter the expansion phase.  Its rate of growth may slow as competitors take some of the company's market share.  Companies at this stage generally increase their dividend payout ratio to approximately 30 to 40% of earnings.

5.  The Maturity Phase:  Companies can continue to expand even as they reach their maturity phase, but their growth rate usually slows measurably.   Well-run mature companies can continue to be a competitive force in their respective industries for decades or even several generations.  Many of the companies in this group are mature companies, a few over a century old.  It is during this stage that companies tend to increase their dividend payout ratios to 50 to 60% of earnings, which provides investors with generous dividend income.

6.  The Decline Phase:  In the later stages, many companies fail to innovate - to keep their competitive advantage.  These companies will enter the decline phase, and unless they reinvent themselves, they will eventually cease to exist.  In this phase, as sales and profits decline, they will eventually reduce or eliminate their dividend payouts. 

Beware of attempting to buy or hold the stock of a company in the final stages of its business life cycle.

Business and Dividend Life Cycles
Start Up

Growth Rate 20%
Dividend Payout Ratio 0%

Early Growth
Growth Rate 30%
Dividend Payout Ratio 0%

Late Stage Growth
Growth Rate 35%
Dividend Payout Ratio 15%

Expansion
Growth Rate 25%
Dividend Payout Ratio 30%

Maturity
Growth Rate 20%
Dividend Payout Ratio 55%

Decline
Growth Rate < 5% and declining
Dividend Payout Ratio < 20%


AT&T is a great example of a company currently in decline, possibly on its way to extinction. 

Beware of attempting to buy or hold the stock of a company in the final stages of its business life cycle.

At one time, AT&T was the most widely held stock in America.  The company paid its first dividend in 1893 and became known as the widows and orphans stock because it was such a consistent source of dividend payments for investors.  AT&T's history dates back to 1875.  The company's founder, Alexander Graham Bell, invented the telphone and together with several investors started the American Telephone and Telegraph Corporation.  As a telephone company, AT&T was so successful it achieved regulated monopoly status.  In 1984, the US Department of Justice broke the AT&T monopoly into eight companies:  seven regional operating "Bells" and AT&T.

For most of its history, AT&T had been largely insulated from market pressures and competitive forces.  After the break up, smaller and leaner communication companies stole AT&T's market share, first through price competition and later by becoming product innovators.  For the new AT&T to successfully compete in an unregulated environment, it would require a drastic change in corporate culture.  Over the past few years, operations and profits have continued to decline, and AT&T is now struggling to survive. 

AT&T's story of dominance and decline highlights the constant need for you to follow up your initial purchase analysis with a routine review to see if the companies you hold are performing as expected. 

• Each time you decide to continue to hold a stock, you are in fact making a new buying decision. 
• Understanding the business life cycle outlined above will enable you to identify companies that are about to emerge as great dividend payers, as well as help you to spot the mature companies headed down the road to extinction.