Challenging the Financial World (Growth Part 4 of 8)

In this video I am going to be challenging one of the most cherished ideas in Finance: The Dividend Pricing Model. Watch now!

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We are talking about growth. Everything we have discussed up to this point, has been ideas that are well accepted in the financial world. This video is going to change that, because I am going to be challenging the status quo. Finance is one area of academia where they hate when you challenge the establishment. If you challenge your professor, you are out of the classroom. Well, buckle up, because I am taking on one of the most cherished ideas in Finance: The Dividend Pricing Model.

So far in this video series on Growth, we have discussed three main ideas:

1. Growth exists
2. Growth continues forever
3. Growth is exponential

There are many different curves you can draw that fit these three ideas. So it is helpful if we can get a more thorough definition of the curve of growth. Now we are going to add one more characteristic of growth.

• Growth rates decrease over time

It is important to realize how controversial this statement is. This statement goes against one of the most cherished mathematical equations in all of finance: The Dividend Pricing Model. In all honesty, The Dividend Pricing Model is my favorite finance equation, and I have made a four part video series on this channel if you want to know more about it. The Dividend Pricing Model has flaws, but no one talks about them, because this math equation is so accepted within the Finance community. I am going to challenge it today, because there are flaws in the Dividend Pricing Model, and it is affecting your business.

Let me explain the problem. The Dividend Pricing Model is based on the assumption of a constant growth rate. You hear this all the time from finance professionals. You might hear someone say, “This company is going to grow 10% Year over Year into the future.” That is not a very accurate way to describe growth, because in the real world, growth rates decrease over time. As a business grows larger, it becomes harder and harder to maintain a constant growth rate.

This is very easy to illustrate. Imagine you owned a company worth $100M. Let us say you doubled the size of that company in one year. You experienced 100% growth. Now the company is worth $200M. If your growth remained constant at 100%, in one more year the company would be worth $400M. In one more year it would be worth $800M. You can quickly see why a constant growth rate becomes unrealistic. The larger a company becomes, the harder it is to maintain the same growth rate. Everyone hates to see decreasing growth rates, but in the big picture, it does not really matter, because the actual size of the company keeps growing, even at smaller percentages.

It is actually more accurate to have a decreasing growth rate over time. Maybe it goes from 100% to 95% to 90% in three years. We see this in economic data, massive companies have a much harder time achieving high growth rates than small companies. This is something everyone knows. Everyone knows that growth rates decrease over time. But that understanding is not reflected in the financial equations we all use every day. Instead, the Dividend Pricing Model says the opposite, that growth rates remain constant. This creates one of the great discrepancies in finance. The impact is huge. Most people do not realize, but this math equation touches every aspect of your financial life.

Let me be specific, because most people do not realize what a big deal this is. The Dividend Pricing Model is used as the continuing value formula in stock valuation. McKinsey & Company publishes a text book on stock valuation, and in their examples, the continuing value formula accounts for 56 to 125% over an eight year forecast period. This simple math equation is a major driver of financial markets, and there is a flaw in the formula.

I have a solution. I have developed a new financial equation I call the Theory of Credit Markets. This is a math equation. It does not replace the Dividend Pricing Model. Instead, it works with the Dividend Pricing Model to correct this error.

Let me show you the impact. Here is a graph of growth over ten years using the two different methods. One calculates growth using the Dividend Pricing Model, and one calculates growth using the Theory of Credit Markets. Can you see the difference?

If we extend this same chart over twenty years, the different approaches become very obvious. After only twenty years, the Dividend Pricing Model gives you outrageous results, and the Theory of Credit Markets delivers much more realistic results.

How did all this come about if there is an obvious flaw in the equation. It does make sense. The reason we originally used the Dividend Pricing Model is because it was a shortcut. Everyone started using it about fifty years ago. Fifty years ago, people did not have computers. So if you were performing stock valuations by hand, you needed a simple tool that assumes straight line growth. The Dividend Pricing Model is very efficient, and I would have used it to. But today we have computers. Today we can use more complicated mathematics to achieve more accurate results. But now we have another problem… no one wants to challenge the status quo. I am providing an alternative called the Theory of Credit Markets that uses decreasing growth rates.

The goal here is to have an accurate understanding of growth to help people make decisions in their business today. The characteristics we have discussed so far are:

1. Growth exists
2. Growth continues forever
3. Growth is exponential
4. Growth rates decrease over time

I know this is controversial, but these financial tools can help you. On a practical level, when you are working in a high growth company, there is a lot of uncertainty about the future. You are making decisions in real time. You have to decide whether to be aggressive or conservative in growing the business. Are you going to hire fast or hire slow? These are difficult decisions, and hiring too fast or too slow are equally bad. As a business leader you have to look into the future and determine the best level to grow your business. The curve of growth is the financial tool that can help you make decisions.

Leave a comment down below letting me know what you think!

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Neither Zach De Gregorio or Wolves and Finance Inc. shall be liable for any damages related to information in this video. It is recommended you contact a CPA in your area for business advice.