The H Model for valuing Growth

The H model is a two-stage model for growth, but unlike the classical two-stage model, the growth rate in the initial growth phase is not constant but declines linearly over time to reach the stable growth rate in steady stage. This model was presented in Fuller and Hsia (1984).

The Model

The model is based upon the assumption that the earnings growth rate starts at a high initial rate (ga) and declines linearly over the extraordinary growth period (which is assumed to last 2H periods) to a stable growth rate (gn). It also assumes that the dividend payout and cost of equity are constant over time and are not affected by the shifting growth rates. Figure 13.4 graphs the expected growth over time in the H Model.

Figure 13.4: Expected Growth in the H Model

Figure 13.4: Expected Growth in the H Model

Extraordinary growth phase: 2H years Infinite growth phase

The value of expected dividends in the H Model can be written as:

Stable growth Extraordinary growth where,

P0 = Value of the firm now per share, DPSt = DPS in year t ke= Cost of equity ga = Growth rate initially gn = Growth rate at end of 2H years, applies forever afterwards Limitations

This model avoids the problems associated with the growth rate dropping precipitously from the high growth to the stable growth phase, but it does so at a cost. First, the decline in the growth rate is expected to follow the strict structure laid out in the model -it drops in linear increments each year based upon the initial growth rate, the stable growth rate and the length of the extraordinary growth period. While small deviations from this assumption do not affect the value significantly, large deviations can cause problems. Second, the assumption that the payout ratio is constant through both phases of growth exposes the analyst to an inconsistency -- as growth rates decline the payout ratio usually increases.

Works best for:

The allowance for a gradual decrease in growth rates over time may make this a useful model for firms which are growing rapidly right now, but where the growth is expected to decline gradually over time as the firms get larger and the differential advantage they have over their competitors declines. The assumption that the payout ratio is constant, however, makes this an inappropriate model to use for any firm that has low or no dividends currently. Thus, the model, by requiring a combination of high growth and high payout, may be quite limited4 in its applicability.

Illustration 13.7: Valuing with the H model: Alcatel

Alcatel is a French telecommunications firm, paid dividends per share of 0.72 Ffr on earnings per share of 1.25 Ffr in 2000. The firm's earnings per share had grown at 12% over the prior 5 years but the growth rate is expected to decline linearly over the next 10 years to 5%, while the payout ratio remains unchanged. The beta for the stock is 0.8, the riskfree rate is 5.1% and the market risk premium is 4%.

4 Proponents of the model would argue that using a steady state payout ratio for firms which pay little or no dividends is likely to cause only small errors in the valuation.

Cost of equity = 5.1% + 0.8*4% = 8.30% The stock can be valued using the H model:

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