What is a supernormal growth title?
A stock with supernormal growth is a stock that is experiencing particularly robust growth growth for a while, then eventually returns to normal growth levels. During their supernormal growth phase, these stocks surpass the market significantly and offer investors Return which are well above average. To be considered a supernormal growth stock, earnings must continue to grow at an unusually rapid rate for at least a year.
Key points to remember
- Supernormal growth is a period of increased income, lasting a year or more.
- Periods of supernormal growth are not sustainable in the long term, as competition or market saturation eventually leads to lower levels of growth.
- Finding a fair value for a supernormal growth stock is difficult, often requiring a pricing model for the supernormal growth period and the normal growth period.
Understanding a Supernormal Growth Stock
Supernormal growth stocks exhibit exceptionally rapid growth over an extended period – a year or more – that typically exceeds any simultaneous growth in the overall economy. The period of abnormally rapid growth of a company’s stock cannot be sustained indefinitely. Eventually, competitors will enter the market and catch up with the business. Then profits will likely drop to a level more in line with competition and the overall economy. In addition to the term “supernormal”, the idioms “non-constant growth” and “erratic growth” can be applied to stocks that experience this pattern of escalating growth.
Supernormal growth is considered a regular part of a industry life cycle, especially when there is a high demand for a new product. Thus, some startups naturally go through a phase of supernormal growth. Many of the most successful companies in history have experienced supernormal growth at some point in their development.
During their early years in particular, future blue chip stocks will often appreciate at levels much higher than the general market averages. These profits then stabilize and the action can become a safe bet. Or if the business has only produced one fad, profits may drop dramatically after the growth phase and the business remains small or disappears altogether.
What causes the supernormal growth of stocks?
A number of factors can trigger exceptionally rapid growth for a stock: the launch of an exciting new product or technology; creating an innovative business model or marketing strategy; or launch an essential service.
A company can also achieve supernormal growth by owning a patent, first mover advantage, or another factor that provides a temporary lead in a specific market. Additionally, an unusual growth spurt may occur due to situations that affect the economic environment. For example, an engineering company may experience a surge in stock price and earnings during unprecedented growth and demand in the construction industry. Another example of a supernormal growth trigger might be when a company launches a successful new product based on artificial intelligence (AI) before AI technologies became mainstream.
The Challenge of Assessing Supernormal Growth Stocks
Valuing stocks can be quite complicated, but putting a value on fast-growing companies can be tricky. Stocks with non-constant supernormal growth cannot be valued in the same way as companies whose earnings are expected to grow at a constant rate, i.e. in line with the economy, for the foreseeable future. For steadily growing stocks, it’s generally good to stick with the Gordon’s growth model of valuation. Gordon’s growth model, also known as dividend discount model (DDM), is a method of calculating the intrinsic value of a share, outside current market conditions. The model equates this value to the present value (PV) of a stock’s future dividends.
Although Gordon’s growth model is one of the simplest Evaluation formulas, it does not take into account any changes in dividend growth over time. Therefore, it is difficult to use this model accurately for supernormal stocks. In these cases, you need to know how to calculate value during the company’s early years of high growth and later years of lower steady growth. In order to account for the slightly more volatile dividend/earnings activity of supernormal growth stocks, we can use a “two-step” or “in several stages» DDM instead. The basic two-stage model assumes a constant, extraordinary rate for the period of supernormal growth followed by a constant, normal growth rate thereafter; and the difference between these two growth rates can be substantial.
A possible limitation of the two-stage model is that the transition from the initial period of abnormal growth to the final period of steady-state growth can be abrupt; and in some cases a smoother transition to mature phase growth rate would be more realistic. Thus, academics and quantitative analysts developed variations of the two-stage model in which growth begins at a high rate and declines in linear increments throughout the period of supernormal growth until it reaches a normal rate at the end.
Real-world example of a supernormal growth stock
Netflix Inc. had several years of supernormal growth in its early days, but those were short-lived as profits slumped again with a year or two.
A period of sustained supernormal growth began in 2016. In 2015, the company made $0.29 in earnings per share (EPS), then $0.44 in 2016, a jump of 52%. In 2017, EPS was $1.29 (193% jump), then $2.78 in 2018 (116%). Earnings continued to rise in 2019, to $4.28, a 54% jump.
Such growth rates can only be sustained for so long. In Netflix’s case, there’s only a certain number of people who want to subscribe, and only a certain price they’re willing to pay for the service. Increased competition will also hurt long-term growth rates. That doesn’t mean they can’t continue to grow and do very well, but profits will eventually normalize. The growth streak could continue, or even accelerate, before that happens. Supernormal growth can last for several years in some cases. For other companies, it’s short-lived.
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