by Russell J.

Fuller and Chi-Cheng Hsia

A Simplified Common Stocic Vaiuation

Modei
A simplified stock valuation model based on the general principle that the price of
a common stock equals the present value of its future dividends, the H-model is
more practical than the general dividend discount model, yet more realistic than
the constant growth rate model. The H-model assumes that a firm's growth rate
declines (or increases) in a linear fashion from an above-normal (or below-normal)
rate to a normal, long-term rate. Given estimates of these two growth rates, the
length of the period of above-normal growth, and the discount rate, an analyst
may use the H-model to solve for current stock price.
Like the popular three-phase model, the H-model allows for changing dividend
growth rates over time. The H-model thus yields results similar to those of the
three-phase model. But the H-model is much easier to use, requiring only simple
arithmetic. Furthermore, it allows for direct solution of the discount rate, or cost of
equity, whereas more complicated models can give numerical solutions only
through trial and error.

ECURITY ANALYSTS NEED common

stock valuation models to estimate "correct" prices for shares of common stock
and to determine the stock's expected return,
given its current price. Ideally, practitioners
and academicswould like a model that (1) is
conceptually sound, (2) requires relatively few
estimates, (3) allows some flexibility in describing dividend growth rate patterns, and (4) allows straightforward calculation of either the
price (given the discount rate) or the discount
rate (given the price). None of the common
valuation models currently in use satisfies more
than three of these objectives. The H-model,
described below, satisfies all four.

where
Po = the current stock price,
Dt = expected dividend in period t, and
r = the appropriate discount rate.
Although theoretically sound, the dividend discount model is not practical because it requires
the estimates of an infinite, or at least a very
long, dividend stream. In addition, it does not
allow for direct solution of the discount rate.
The more practical constant growth dividend
discount model greatly simplifies the problem
of estimating future dividends. It assumes that
dividends grow at a constant rate forever, so
that the price of a share of common stock may
be calculated as follows:
Po =

Current Models
The general dividend discount model states that
current stock price equals the present value of
all expected dividends. This is stated mathematically as:
(1)

.= . (1

Do(l + g)

(2)

r - g

where
Do = the dividend paid in the most recent 12
months and
Russell Fuller is Vice President of Conners iniKStor Services and Chi-Cheng Hsia is Professor of Finance at Washington State University.

FINANCIAL ANALYSTS JOURNAL / SEPTEMBER-OCTOBER 1984 D 4 9

Figure A Constant Growth Model

Figure B Three-Phase Model

g = the constant, perpetual dividend growth

rate.
Figure A illustrates the pattern of dividend
growth rates over time (gt) according to the
constant growth model.
In addition to simplicity, one of the advantages of the constant growth model is that it
allows for direct solution of the discount rate,
given the current stock price and an estimate of
g. One merely has to rearrange the terms of
Equation (2) to get:
Do(l + g)

rate (gn), which is assumed to persist from the

year B onward.^ Thus gn may be thought of as a
long-run, steady-state, or "normal" growth rate
for the firm.
In practice, the three-phase model allows for
calculation of all future dividends, given estimates of the growth rate during Phase 1 (ga), the
length of Phases 1 (A) and 2 (B), the long-run,
normal growth rate during Phase 3 (gn), and the
appropriate discount rate (r). The present value
(PV) of all future dividends may be written as:^
Po = PV (Phase 1) + PV (Phase 2)

(3)

+ PV (Phase 3),

The problem with the constant growth mod- or

el, however, is that dividend growth rates are
not constant. The growth rates of many stocks
fluctuate so much that the constant growth
model cannot even provide a good first approximation.
Security analysts have developed alternative
valuation models that tend to be more complicated than the constant growth model but not as
DB(1 + gn)
(4)
complex as the general dividend discount mod(1 + r)(r - g j '
el. The three-phase dividend discount model,
for example, is based on a dividend growth rate where DB is the dividend in year B and growth
pattern similar to that illustrated in Figure B.' In declines during the transition phase in the folPhase 1, dividends are expected to grow at a lowing hnear fashion:
constant rate (denoted ga) for a period of A
t - A
years. During Phase 2 (a transition phase lasting
gt = ga - (ga - gn)
for B - A years), the dividend growth rate
declines in a linear fashion to a constant growth for
1. Footnotes appear at end of article
(A -I- 1) < t < B.
FINANCIAL ANALYSTS JOURNAL / SEPTEMBER-OCTOBER 1984 D 5 0

The three-phase model has several attributes

that make it popular with practitioners. First,
because it assumes constant growth in Phase 3,
the analyst does not have to estimate a perpetual stream of dividends. Instead, only five estimates are needed to calculate the stock price.
Second, the model is much more flexible than
the constant growth model, because it allows
for some change in dividend growth rates over
time. Finally, although the necessary calculations are fairly complex. Equation (4) may be
solved by developing algorithms for use on
programmable calculators or computers.'*
The three-phase model does have drawbacks,
however. First, if Phases 1 and 2 cover more
than two or three years, solving for the price
becomes tedious. Second, Equation (4) does not
allow one to solve analytically for r; rather, one
has to "guess" at a discount rate, solve for Po,
compare this figure with the current market
price, then guess again using a higher (lower)
discount rate if the calculated Po was higher
(lower) than the current price. This iterative
process is continued until one arrives at a discount rate that results in a price that approximates current market price.
Deriving the H-Model
Consider the "two-step" dividend growth rate
pattern illustrated in Figure C. Initially, dividends grow at a constant rate of ga for A years.
Thereafter, dividends grow at a constant rate of
gn. Given these assumptions, the present value
Figure C Two-Step Growth Rate

of the future dividend stream can be calculated

.5

as:

Po = PV (Step 1) + PV (Step 2),

or

(1 + gn)'t - A
(1 + r)'

(5)

where DA is the dividend in year A.

If we solve for the geometric progressions and
assume that r exceeds gn. Equation (5) may be
simplified to:
Po =

Do(l + ga)

I A-l

1 -

gn

1 + r

(6)

Equation (6) could be used to estimate Po, but it

has two drawbacks as a common stock valuation model. First, it is very tedious to solve for r,
the discount rate, directly from Equation (6).
Second, the dividend growth rate pattern assumedthat is, a constant growth rate for A
years followed by a sudden jump to a long-run,
normal growth rateis highly unlikely.
A more realistic, yet operational, model is
given by Equation (7), which approximates
Equation (6):^
Po =

[(1 + gn) + A(ga - gn)]. (7)

This general process may be extended beyond

two steps. For example, a three-step growth
rate pattern is illustrated in Figure D. In this
case, dividends are expected initially to grow at
a constant rate of ga for A years; the growth rate
then jumps to a level of gb, which lasts for B A years; at the end of B years, the growth jumps
to a long-run, normal level of gn. The present
value of dividends for this three-step model can
be approximated as:
Po =

^ [(1 + gn) + A(ga - gn)

gn
+ ( B - A)(gb- gn)].

(8)

This general procedure can be repeated for as

many "steps" as one wishes to consider.^ We
FINANCIAL ANALYSTS JOURNAL / SEPTEMBER-OCTOBER 1984 D 5 1

Figure D Three-Step Growth Rate

mates that XYZ Company, which has just paid a

one dollar dividend, will experience a long-run
normal growth rate of 8 per cent and that the
appropriate discount rate is 14 per cent. The
analyst expects, however, that the growth rate
will be above normal for the next 10 years,
starting out at 12 per cent and declining in a
linear fashion until it reaches 8 per cent at the
end of the 10 years. Because the total period of
above-normal growth is 10 years, the halfway
point (H) is five years. The analyst thus has the
following estimates:

tk
ga

1
1
1

8b

gn

1
1
1

ga = 12%
gn = 8%,
r = 14%,
Do = $1.00, and
H = 5 years.

Using Equation (9), he can estimate the price for

the stock as follows:
will stop at three steps here, however, for two
reasons. First, increasing the number of steps
increases the complexity of the model until it
approaches the complexity of Equation (1), the
general dividend discount model. As we add
more steps, we begin to defeat our purpose,
which is to develop a simple and operational
model. Second, by making one additional assumption, we can inodify Equation (8) so that it
is very similar to the three-phase model in
current use and, at the same time, further
simplify Equation (8).
To do this, assume that gb, the "middle step"
growth rate, is exacfly halfway between ga and
gn, SO that:
ga + gn
gb =

Substituting this into Equation (8) yields:

A + B

Do
(1 + gn) +

- gn)

Now substitute H for (A -I- B)/2, and we have

the H-model:
Po =

[( + gn) + H(ga - gn)].

(9)

We have eliminated gb from the equation and

have to estimate only the beginning growth rate
(ga) and the long-run growth rate (gn). We have
made H the "halfway" point for the period of
above-normal growth.
Suppose, for illustration, that an analyst esti-

$1.00
Po =

0.14 - 0.08

[1.08 + 5(0.12 - 0.08)]

= $21.33.

H-Model Features
The H-model has several pleasing features.
There are no exponential terms; solving for Po
involves only simple arithmetic. Also, to solve
analytically for the discount rate, the terms in
Equation (9) have only to be rearranged as
follows:
= ^

[(1 +

+ H(ga - gn)] + gn-

(10)

I0

If ga equals gn. Equation (10) reduces to Equation (3) of the constant growth model. In any
case, solving for r by Equation (10) is straightforward.
The H-model implies a growth rate pattern
over time that seems (to us at least) to be
plausible for many firms.* Figure E illustrates
the implicit pattern. The growth rate, beginning
at ga, declines in a steady fashion from ga to gn
over a period of 2H years. The growth rate is
halfway between ga and gn at year H and
reaches gn at the year 2H. (If ga is estimated to
be less than gn, then the line would slope
upwards toward gn over time.) This growth rate
pattern seems more likely than a two or threestep pattern (Figures C and D) with sudden
jumps from ga to gb to gn, and perhaps more
likely than the linear segments of the threephase model (Figure B).
5?^ . ,

FINANCIAL ANALYSTS JOURNAL / SEPTEMBER-OCTOBER 1984 Q 5 2

Figure F H-Model vs. Tlirco-Phnso Model

Figure E H-Model Implicit Growth Rate

8.1

.so
Sa + Sh
2

1
Sn

1 . ,
1.

1
1

1
1
1
1
H

11
1

> -

1
1
1

11

1
1

1
1
1)

13

211

DoH(ga - gn)
gn

The second term represents the incremental

value due to the temporary above-normal
growth. Consider, for example, the case of XYZ
Company. Using Equation (11), we can see that
its total price of $21.33 is composed of $18,000
from normal growth prospects and $3.33 from
temporary, above-normal growth, or:
$1.00(1.08)

Analysts should also find the H-model intuitively appealing. Suppose investors believe
that a firm's normal growth rate is equal to gn,
but believe that the firm currently has unusual
investment opportunities and therefore will
grow at an above-normal rate for the next 2H
years. In this case. Equation (9) of the H-model
indicates that the value of the stock is equal to
the capitalized value of the dividends assuming
normal growth (gn) plus the additional value
from the above-normal growth (ga). This interpretation becomes clearer if we rewrite Equation
(9) as follows:
Do(l

^^^ H-moiliI

$1.00(5)(0.12 - 0.08)

Po =

0.14 - 0.08
0.14 - 0.08
= 18.00 + 3.33 = $21.33.

Finally, the H-model is directly comparable to

the three-phase model. Both models require an
estimate of the initial growth rate (ga), the longrun, normal growth rate (gn) and the discount
rate (r). The three-phase model requires an

estimate of Phase 1 (A years) and Phase 2 (B-A

years), whereas the H-model requires only an
estimate of Hthe halfway point.
Figure F compares the growth rate pattern of
the three-phase model with the implicit growth
rate pattern of the H-model. The H-model's
assumption that gb equals (ga-l-gn)/2 puts H
exactly halfway between the A and B of the
three-phase model. Thus H can be thought of in
either of two ways(1) as one-half the time
required for the firm's growth rate to decline
from its initial level (ga) to the firm's long-run
normal growth rate (gn) or (2) as the point
halfway through the transition phase (Phase 2)
of the three-phase model.
As Equation (4) suggests, the three-phase
model is relatively complex and requires either a
programmable calculator or a computer, or a lot
of time and patience. The H-model can be
solved using simple arithmetic. In addition, the
H-model can be used to solve analytically for
the discount rate, using Equation (10). By contrast, the three-phase model requires an iterative process to solve for r. If the H-model
generates results that are similar to those of the
three-phase model, then it might be considered
as a replacement for the three-phase model.
H-Model Results
Table I presents for six hypothetical cases
estimated prices generated by the H-model and
the three-phase model. In Case 1, ga, gn and r
estimates are 7, 4 and 9 per cent, respectively,
for both models. For the three-phase model, A
(the length of Phase 1) is estimated at five years

FINANCIAL ANALYSTS JOURNAL / SEPTEMBER-OCTOBER 1984 D 5 3

1
1

1 t

2H

Table I H-Model vs. the Three-Phase Model

Case
No.
1

2
3
4
5
6

gu
7%,
12
12
-2
20
20

/I

9%

5yr.
5yr.
5yr.
3yr.
7yr.
3yr.

7yr.
7yr.
15 yr.
5yr.
13 yr.
7yr.

4%
4
4
4
4
4

Po

Ratio of
Estimated
Prices

6 yr.
6 yr.
10 yr.
4 yr.
10 yr.
5yr.

$24.40
30.40
36.80
16.00
52.80
36.80

0.98
0.98
1.02
1.07
1.29
1.03

H-Model

Three-Phase

Common Assumptions*

9
9
9
9
9

Po
$23.97
30.17
37.66
17.12
68.18
38.04

* Do equals $1.00 in each case.

and B (the end of Phase 2) is estimated at seven

years. The transition period, B-A, thus lasts for
two years. Civen these assumptions, and the
one dollar dividend assumption, the threephase model generates a price of $23.97. The Hmodel, where H is set at six years (halfway
through the transition phase of the three-phase
model), generates a price of $24.40.
In Case 2, the beginning growth rate assumption is increased to 12 per cent, while other
estimates remain the same. The results of the
two models are again extremely close$30.17
for the three-phase model, versus $30.40 for the
H-model. In Case 3, the transition period for the
three-phase model is lengthened to 10 years, so
that H, the halfway point of the H-model,
becomes 10 years. Again, the answers generated by the two models are similar$37.66 versus
$36.80.
Case 4 covers the possibility that the beginning growth rate is less than the long-run,
normal growth rate. Although the answers generated by the two models in this case are not as
close as in the first three cases, they are only
$1.12 apart$17.12 versus $16.00.
Case 5 illustrates the circumstances under
which the two models will give answers that are
not reasonably close. This will occur when (1)
there is a large difference between the beginning growth rate and the long-run, normal
growth rate; (2) the time period over which the
annual growth rates approach gn is relatively
long; and (3) the difference between the discount rate and the initial growth rate is relatively large.' In Case 5, the three-phase model
generates a price of $68.18, whereas the Hmodel generates a price of $52.80.
It seems unlikely that such a wide difference
between the beginning growth rate and the
long-run growth rate20 per cent versus 4 per
cent would persist for very long. Over shorter
periods, however, such a difference may not be

uncommon. Case 6 shows that, under these

conditions, the two models provide very similar
prices$38.04 versus $36.80.
Under most plausible circumstances, then,
the two models provide price estimates that are
remarkably similar. This is borne out by the last
column of Table I, which presents the ratio of
the prices generated by the two models. With
the exception of Case 5, the ratios are close to
1.0, indicating that the prices are within a few
percentage points of one another.'
Using the H-Model
To see exactly how the H-model might be used
to identify under or overpriced stocks, consider
the case of IBM. In February 1982, IBM was
selling for $62 per share. At that time. Value
Line was forecasting a dividend growth rate of
12 per cent for IBM for the next five years. Value
Line does not publish estimates of long-run,
normal growth rates or transition periods, but
we will assume that IBM's long-run, normal
dividend growth rate is 7 per cent, or slightly
above the average growth rate for industrial
stocks." We'll further assume that its growth
rate will decline from 12 to 7 per cent over a
period of 22 years, so that the halfway point, H,
is 11 years. We thus have:
ga = 12%,
gn = 7%, and
H = 11.
To determine the appropriate discount rate,
or the "required return," we'll use the following
Security Market Line:'"^
' required r = 10% -I- 6%.

(12)

Using Value Line's estimate of IBM's beta in

19820.95gives us a required return of 15.7
per cent. Given these estimates and IBM's 1981
dividend of $3.44, the H-model gives us a price
for IBM of $64.06. Comparing this model price

FINANCIAL ANALYSTS JOURNAL / SEPTEMBER-OCTOBER 1984 n 54

with the market price of $62 suggests that IBM

was slightly underpriced. Of course, different
estimates of the dividend growth rates and the
required return would yield different results.
The H-model, like every other model, can be no
better than the estimates used as inputs.
The H-model can also be used to determine
the cost of equity, or expected return. This is the
return investors expect, given the current stock
price and their estimates of future dividend
growth rates. For example, given the market
price of $62 and the above estimates for IBM,
the expected return for IBM would be 16.0 per
cent, based on Equation (10) of the H-model:
expected r =

$3.44
$62

2. The growth rate during Phase 1 (ga) does not

have to be greater than the constant, steady-state
growth rate (gn) assumed for Phase 3. If gn
exceeds ga, then the growth rate increases in a
linear fashion from ga to gn during Phase 2, the
transition phase. However, gn does have to be
less than r; otherwise, the stock price would be
infinite because dividends would be growing at a
faster rate than the rate at which they are being
discounted.
3. For the derivation of the three-phase model, see
Fuller, "Programming the Three-Phase Dividend
Discount Model," op dt.
4. Ihid.
5. This two-step model has been presented previcontinued

[(1.07) + 11(0.12-0.07)]
0.07 = 0.160.

^Beneficiar

Calculating the cost of equity using the H-model

is straightforward. By contrast, the same calculation using the three-phase model requires an
iterative process and, for all practical purposes,
a computer.
Finally, the H-model allows investors to calculate security alphasi.e., the difference between the expected return and the required
return. IBM's alpha would be calculated as
follows:

220th Consecutive
Quarterly
Common Stock
Dividend

IBM alpha = 16.0% - 15.7% = -hO.3%.

Beneficial Corporation has

announced per share dividends
payable June 30, 1984 to
stockholders of record at the
close of business June 4, 1984.

The positive alpha is consistent with the earlier

conclusion that IBM was slightly underpriced.
We hope the H-model will prove to be a
useful addition to the analyst's tool kit. Like any
other tool, however, it is only of value when
properly used. Without sound estimates of
growth rates and required returns, the H-model
can provide little useful information. With
them, it offers a theoretically sound and practically efficient approach to stock valuation.

Common Stock
Quarterly $.50

Footnotes

Payable July 31, 1984 to stockholders of record at the close of

business July 6,1984.

1. The three-phase model has been proposed in the

literature by Nicholas Molodovsky, Catherine
May and Sherman Chottiner, "Common Stock
ValuationPrinciples, Tables, and Applications," Financial Analysts Journal, March/April

5% Cumulative Preferred
Stock Semi annual $1.25
$4.50 Dividend Cumulative
Preferred Stock Semi-annual

-$2.25

$5.50 Dividend Cumulative

Convertible Preferred Stock
Quarterly - $1,375

1965; W. Scott Bauman, "Investment Returns and

Present Values," Financial Analysts Journal, No-

vember/December 1969; and Russell J. Fuller,

"Programming the Three-Phase Dividend Discount Model," Journal of Portfolio Management,

May 23,1984

Beneficial corporation

Summer 1979.
HNANCIAL ANALYSTS JOURNAL / SEPTEMBER-OCTOBER 1984 Q 5 5

$24.00, and the ratio of the two would be 1.08.

ously in the literature in an attempt to provide a
Thus if the difference between ga and r is relativecommon stock valuation model that is more really small, the results of the two models are similar,
istic than the constant growth model. See J. Fred
even if there is an unusually large difference
Weston and Eugene F. Brigham, Managerial Fibetween ga and gn and the transition period is
nance (Hinsdale, 111.: The Dry den Press, 1978),
relatively long.
pp. 690-692.
The formal derivation of the H-model as well as 10. If, as in Case 5, ga is much greater than r and ga
approaches gn over a long time period, then the
the N-step model is available from the authors.
three-phase model will always generate answers
The generalized N-step model is:
that are substantially larger than the H-model's.
Under these circumstances, the analyst will have
+ X|(g,-gn) + X:{g:-gn) +
^
to decide which growth rate pattern most closely
resembles the pattern he foresees for the firm's
dividend stream.
. . .+
11. Most studies of historical stock returns have
found the average dividend growth rate to be in
where the "X"s represent the length of time for
the 4 to 5 per cent range over the period from
each step.
1926 to the late '70s. We increased this to 7 per
8. In the process of deriving the H-model, the time
cent for IBM to adjust for a higher long-run state
dimension was suppressed. (Note there is no
of inflation and slightly better long-run prospects
subscript t in Equation (9)). Thus there is only an
for IBM than the typical stock.
implicit growth rate pattern over time in the H12. Historically, the Security Market Line has avermodel. However, it can be shown that the implicaged approximately a 4 per cent intercept (roughit growth rate pattern begins at g., and declines
ly the risk-free rate) and a 5 per cent risk premi(or rises) in a linear fashion, reaching gn at the
um, where risk is measured in terms of beta.
point in time of 2H, as Figure E illustrates.
Thus the typical stock has averaged approximate9. If a discount rate of 15 per cent is used in Case 5,
ly a 9 per cent return in the past. To adjust for
the difference between g^, and r is 0.05
current market conditions, we increased the risk(0.20-0.15) instead of 0.11 (0.20-0.09). Under
free rate to 10 per cent and the risk premium to 6
these circumstances, the three-phase model price
per cent.
would be $25.98, the H-model price would be

Pension Fund Perspective

corporate managements from acting

against the interests of shareholders,
In June, Congressman Timothy but they don't go far enough. If the
Wirth (Democrat, Colorado) intro- trustees of the Grumman pension
duced legislation that incorporates fund had served jail terms and if cormany recommendations of the Securi- porate managements involved in
ties and Exchange Commission (SEC). shareholder suits could be held perThe bill would (1) prohibit companies sonally liable for damages and legal
from making tender offers for their expenses, we would probably see fewown stock as a defense in a hostile er incidents of the use of pension and
takeover attempt; (2) bar target compa- corporate assets to defeat tender offers
nies from issuing "golden parachutes" and possible proxy fights. Finally, the
during a tender offer period; (3) forbid conversions to two classes of securities
target companies from issuing a new for voting purposes should be outclass of securities or more than 5 per lawed by the SEC; otherwise the procent of a class or securities affecting posed rule changes will have little efmore than 5 per cent of the voting fect. It goes against the fundamental
rights; and (4) require shareholder ap- tenets of capitalism to strip investors
proval if a company wants to buy back of their voting rights without compenstock at a premium price from an in- sation. If a family or management
vestor holding more than 3 per cent of group wants to ensure control, they
may buy over 50 per cent of the comthe stock.
These moves will help to prevent mon stock.
continued trom page 17

Takeovers and Shareholders: The

Mounting Controversy . . . T. Boone
Pickens, Robert A. G. Monks, Dean
LeBaron and other important speakers
tell you how they did it, what you
should do about it, and what it all
means . . . On Tuesday, October 30,
1984 . . . The Waldorf Astoria Hotel
. . . New York City . . . A one-day
conference sponsored by the Financial
Analysts Federation. . . .
Call (212) 957-2869 for Registration
Information

FINANCIAL ANALYSTS JOURNAL / SEPTEMBER-OCTOBER 1984 D 5 6