Multistage Dividend Discount Models

Microsoft Corporation has quite a history. It enjoyed such explosive growth in the early years. It was funded with 100% equity, and for decades, stockholders received no cash dividends. All earnings were needed to fund expansion. As earnings per share rapidly grew, so did the stock price, which split multiple times.

What do you think is a _negative_ characteristic of performance for firms in similar positions?

No. This is only the case if debt is larger than assets, and firms in similar positions to Microsoft in the early years would have little or no debt.

Yes! This is the __growth phase__ of development, and the massive investment needed for expansion of young, successful firms often leads to negative free cash flow. They're profitable, sure, but free cash flows can't be used for valuation. It makes sense that dividends would be zero for most of these firms as well, so there's nothing to discount.

That rapid growth doesn't last forever. Eventually, market saturation and competition will slow things down. This is the __transition phase__, such as what Microsoft experienced when its software was on nearly every computer on the planet around the turn of the century. They had plenty of profits left to make, but not a huge amount of growth left. Free cash flow turns positive, and what do you think happens to earnings per share (EPS)?

No. That would indicate a decline, rather than just a transition.

Right! EPS still grows, but more slowly now. New software versions come out, and new ideas are still being formed. But the novelty is largely over. Microsoft moved through this stage in the early 2000s and paid its first of many dividends in 2003.

No. This would suggest an acceleration from the growth phase, which is not typical.

Once the transition is complete, the company is in the __mature stage__. Growth has fallen to a low and predictable level, which may well likely continue long into the future. Nothing too impressive on the horizon, but a solid stream of expected earnings to come. Does this sound like the time to apply the Gordon growth model?

Good call!

Incorrect. This is the perfect time.

Growth during the mature phase has a catchy name: __mature growth rate__. There's the _g_ that you need to plug into the Gordon growth model and come up with a decent estimate of a terminal price. So if you're at the beginning of the next big thing, it might be best to consider history repeating itself. Perhaps it's best to forecast each stage in turn, using the GGM for estimating a terminal price, but modeling growth and transition stage dividends until then.

To summarize: [[summary]]

No. Profits are most likely positive, as indicated by rapidly growing EPS.

Negative equity

Negative profits

Negative free cash flow

EPS falls

EPS grows more slowly

EPS grows more quickly

Yes

No

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