Can someone explain what the second part of the H Model means?
D0H(gs-gl)
dividend times the half life of the declining period in g x the difference in supernormal rate minus the constant rate.
So if they have a high growth rate of 10 that is going to decline to 5 over the next 6 years you would plug in
Div(6/2)(.1-.05)
it is an approximation – look at it as the area of the triangle from gs to gl which is N years apart (N=2*H)
1/2 * N * (gs-gl) is the area of that space. or H * (gs-gl)
If you discounted each years cash flow at that years (r-g*) you might end up with a higher number but this approximation using the area of triangle approach would be pretty close.
The H-model assumes that an initial high growth rate declines linearly (not abruptly like in the two-stage DDM) to an long run average growth rate.
So gs = the initial high growth rate
gl = the long run growth rate.
H - is the period over which the rate is declining. According to the model this is half the period. If the period is 8 then H = (8/2) = 4
Hope this helps.
cpk123’s explanation is right on regarding, why the second part of the equation looks as it is. Area of a triangle with base as transition years and altitude (gs-gl). So, you get Do* H* (gs-gl), where H = half the no of transition years
I know I am a year late, but I had a similar quesiton about the theory behind the H model and i stumbled across thris thread on my google search. I wanted to thank cpk123 and stockjaguar for your help in understanding the model better. I’m very greatful. Thanks!
This is exactly how I remembered it when I took Level 2. It is simply a triangle, and the formula for the area of a triangle is “half of the base times the height”.
The height is the difference between the “supernormal growth” and the constant growth, and the base is the length (in years) of the declining period.