Supernormal Growth Stock

Key Highlights

• Supernormal growth is characterised by a sustained increase in earnings for at least one year.
• The long-term sustainability of such heightened growth becomes challenging due to increased competition or market saturation, resulting in a decline in growth rates.
• Valuing a supernormal growth stock is a complex task, often requiring the utilisation of a pricing model that considers both the period of supernormal growth and the ensuing phase of average development.

What is a Supernormal Stock?

A supernormal growth stock, as defined, is a stock that undergoes a phase of heightened growth for a specific duration but eventually reverts to average growth levels. Throughout this period of supernormal growth, the security surpasses the overall market performance, making it an attractive option for investors seeking substantial returns. For a stock to be categorized as a supernormal growth stock, its earnings must exhibit an extraordinary rate of growth for more than one year.

To illustrate the concept of a supernormal growth stock, consider a startup witnessing tremendous demand for a novel product. Similarly, emerging blue-chip companies may undergo supernormal growth in their initial stages. It's common for many successful companies to experience such extraordinary growth at some point in their development. However, these atypical earnings eventually stabilize, transitioning into a phase of consistent and steady growth over time.

Case Study of Supernormal Growth

Case Study - Supernormal Growth Stock (A recent illustration of supernormal growth is the Indian company, InfoTech Innovations. The company experienced a significant surge in its stock prices during the COVID-19 pandemic, attributed to its cloud-based software facilitating video calls, chat tools, and seamless content sharing. The demand for InfoTech Innovations skyrocketed as businesses in India embraced remote work, and the necessity for video conferencing became paramount. Moreover, the adoption of InfoTech Innovations for remote education, telemedicine, and social networking further fueled its exceptional growth. Before the pandemic, InfoTech Innovations' average share price was ₹670. In April 2020, the company reported an impressive 250 million active participants. By October 2020, the stock price peaked at ₹4,200, accompanied by a proportional increase in earnings.

However, as offices resumed operations and in-person meetings became more common, InfoTech Innovations faced a decline in revenue. The market also witnessed the entry of domestic competitors, such as Bharat Meets and TechTeams, intensifying the competition. As of now, the current market price for InfoTech Innovations is ₹980.

Similarly, another Indian company, MediaStream, followed a comparable life cycle, experiencing supernormal growth in 2017 and 2018, followed by revenue stabilization from 2019 onwards.

Supernormal Growth Stock Valuation

Valuing a stock with a supernormal growth stock poses a considerable challenge, distinct from the valuation of companies with a consistent growth rate. Unlike stocks exhibiting a stable growth pattern, the process of supernormal growth stock valuation necessitates the utilisation of a pricing model tailored for both average and supernormal growth phases.

In the case of stocks characterised by average growth, investors commonly apply the Gordon Growth Model or the Dividend Discount Model for valuation. These models determine intrinsic value by calculating the present value of future dividends. Notably, they need to account for market conditions or variations in dividend growth over time.

Contrastingly, when valuing supernormal growth stocks, the intrinsic value is intricately linked to the company's initial high-growth years and its subsequent phase of comparatively lower average earnings. Consequently, a two-stage or multi-stage dividend discount model is deemed more accurate in capturing the actual value of the stock.

Dividend Discount Model Incorporating Supernormal Growth

Traditionally, the dividend discount model computes the intrinsic value of a stock by considering the dividend for the next period divided by the required rate of return. For instance, with an expected rate of return of 10% and an anticipated dividend of Rs. 1.50 per share, the intrinsic value of the share is determined to be Rs. 15.

However, for companies maintaining a constant dividend, the valuation must incorporate the history of dividend payments, as the economy retains the company's earnings. This involves dividing the expected dividend by the difference between the required rate of return and the dividend payment rate.

In contrast, the dividend discount model with supernormal growth introduces a two-stage approach to dividend payments – average and supernormal.

1. Supernormal Growth: This stage discounts the higher dividend of the next period to the current period, taking into account a supernormal growth rate.

2. Average Growth: This stage signifies the value of a dividend growing at an average rate. The last period of higher growth aids in calculating the price of the remaining dividend. However, the expected return is based on the following year's regular or constant rate dividend.

It's important to note that if there is an abrupt transition between the initial abnormal growth stage and the subsequent phase of steady earnings, the model may lack efficiency. In such cases, the calculated value with the model could be more realistic with a smoother transition to the mature phase. As a result, analysts often utilize model variations that commence with high growth and gradually decline linearly from supernormal to regular periods.

Factors Contributing To Supernormal Growth In Stocks

Several factors can lead to supernormal growth in stocks:

1. Launching a new product line or adopting innovative technology can significantly boost a company's growth trajectory.
2. It is developing a dynamic business plan or marketing strategy that adds strategic depth to the company's operations.
3. We are enhancing overall service quality and customer experience, leading to increased transaction volumes.
4. I am gaining a first-mover advantage by holding a patent or trademark in a particular market.
5. General catalysts such as temporary dominance in a specific market, macroeconomic influences, or groundbreaking technological advancements can also spur supernormal growth in stocks. For instance, a reduction in fuel prices could positively impact an automobile company's stock performance.

Conclusion

In the stock markets, identifying opportune securities and timing is crucial for achieving returns that surpass the ordinary. Investing strategically in stocks experiencing supernormal growth can result in substantial financial gains. It is, therefore, imperative for investors to actively scout for companies exhibiting the potential for supernormal growth opportunities. This proactive approach enhances the likelihood of capturing favourable investment prospects.