The H Model of Valuing Growth is used by investors to value companies or shares of a company with 2 distinctive stages of growth. It is a form of Dividend Discount Valuation, belonging to the set of models called the Gordon Growth Models. It differs from other dividend discount valuation methods in that it attempts to smooth out the growth rate over time, rather than abruptly changing from the high growth period to the stable growth period. The H-model assumes that the growth rate will fall linearly towards the terminal growth rate.
The majority of share issuing companies increase or decrease dividends over time, as opposed to shifting rapidly from high yields to stable growth. Thus, the H-model was invented to approximate the value of a company whose dividend growth rate is expected to change over time.
While other discounted cashflow models measure a company with 2 distinct stages of growth; unstable growth and stable growth, the H Model attempts to smooth out the growth of a firm or company over the course of its unstable or high growth period. To calculate the value of a firm using the H Model of Valuing Growth, the following variables are required.
The original high growth rate is the rate of growth experienced by a firm or company during its unstable growth phase. This can be extremely high or low, and fluctuate from period to period.
The growth rate of a company or firm after a period of instability. It should be noted that instablility isn’t necessarily a bad thing in this sense, as it can be an indication of high growth as a company shifts from a growth phase to a maturity phase in the company’s lifecycle.
The earnings per share this year for a company under analysis. This can be a dividend value or a Free Cashflow to Equity (FCFE) payment. This value is used to predict growth for the duration of the unstable growth phase and into maturity for the firm being analysed.
The rate of return used to discount future cashflows back to their present value, also referred to as the discount rate. This value can also be the Working Average Cost of Capital (WACC) or the required rate of return of an investor to consider investment in the company or shares being evaluated.
The half-life of the investment is the half-life of the high growth period of the company or shares being evaluated. It is the number of expected periods of high growth divided by 2. For example, if a company is expected to experience 10 periods of high growth, the value for H will be 5.
The Value of Shares Today is the present value of shares being evaluated with the H Model after considering all other variables above and applying the H Model formula. It is the final value that investors use to make investment decisions after calculating the H Model value of an investment.
To get a better appreciation for the H Model of Valuing Growth, we will work through the following example. Assume a company has recently issued a dividend of $5, has a required rate of return of 12%, and the expected growth rate is 10% and is expected to fall to 3% over the next 10 years. Using the H Model of Valuing Growth, the value of the company today can be calculated as follows:
V0 = (D0*(1+gn)) / (re - gn) + (D0*H*(ga - gn)) / (re - gn)
V0 = (5*(1+0.03)) / (0.12 – 0.03) + (5*5*(0.1 – 0.03)) / (0.12 – 0.03)
V0 = $76.67
In this example, the value for shares issued by the example company would equal $76.67. An investor can use this value to compare the H Model value of a firm to the market value of the security. If the market value of a security is higher than the H Model value, the security might be considered overvalued, however if the market value is lower than H Model value, it could be assumed that the security is undervalued and may present a potential investment opportunity.
Evidence has shown that the H Model is most accurate when the high growth period is shorter i.e. the model would be less accurate if we assumed a 20 year high growth period instead of a 5 year high growth period, and the accuracy of the model increases when the spread between the long term growth rate and the short term growth rate is less.
The H Model of Valuing Growth is a significant advancement in the field of equity valuation. It solves the problem of the abrupt decline in the growth rates that is assumed by the other models. However, it still provides only an estimate, though a better estimate than standard dividend discount models regarding the valuation of the shares and companies.
The H Model of Valuing Growth is a two stage discounted growth model from the Gordon Growth Model family. It measures the growth of a firm experiencing 2 distinct stages of growth; a high growth phase and a stable maturity growth phase. The H Model attempts to smooth out the growth rate of a firm over time, as opposed to other growth models that simply measure 2 distinct stages. The H Model is one of the most accurate measures of growth to date, used my many investors to evaluate investments in companies that are experiencing fluctuations in growth.
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