Stages of a Company’s Growth

Forecasting a single stable dividend growth rate for a company into the indefinite future is not realistic for many companies because companies experience different growth rates during their life cycles. Therefore, analysts may assume growth may fall into three stages:

i. Growth Phase

Companies are rapidly expanding, with high-profit margins and a high growth rate in earnings per share. These companies have negative free cash flows because they invest heavily in expanding operations. As a result, the dividend payout ratios of growth-phase companies are frequently low or even zero. The company’s growth rate in this phase is called supernormal growth.

ii. Transition Phase

Earnings and sales growth slows due to increased competition and market saturation. The earnings growth declines towards the economic growth rate. Free cash flows turn positive, and dividends payout ratios increase as capital requirements decrease.

iii. Mature Phase

Return on equity nears the required return on equity. The dividend payout ratio, earnings growth, and return on equity stabilize to levels that can be sustained long term. As a result, the Gordon growth model can be used to value the company at this stage. The company’s growth rate is called the mature growth rate.

Question

In which phase would the Gordon growth model only be most appropriate?

1. Growth phase.
2. Transition phase.
3. Mature phase.

Solution

The correct answer C.

The Gordon growth model is most appropriate in the mature phase where the earnings growth rate has stabilized and sustainable in the long run.

B is incorrect. In the transition phase, a company experiences a high growth rate that would eventually decline to a sustainable rate. Therefore, the Gordon growth model would not be appropriate by itself. 

A is incorrect. Under the growth phase, a company would experience multiple growth stages that would make the Gordon growth model not appropriate by itself.

Reading 23: Discounted Dividend Valuation

LOS 23 (i) Explain the growth phase, transition phase, and maturity phase of a business.