Why is the two-stage version of the dividend-growth model often used instead of the basic (one-stage) version?
The two-stage model is used to deal with companies growing at a very rapid rate. One requirement of the dividend-growth model is that r investors’ required rate of return, must be greater than g investors’ forecast of the growth rate of the firm’s dividend stream. In those cases where the firm’s growth rate exceeds investors’ required rate of return the model breaks down, calculating a negative stock price. The two stage version of the model deals with this case by dividing the forecast of future cash flows into two periods of time, or “stages”: a first stage of rapid growth followed by a second stage of more normal growth. In the first stage, the rapid growth of the company prevents the dividend-growth model from applying; instead we calculate each forecasted dividend and its associated present value explicitly. In the second stage the dividend-growth model does apply, and we use it to calculate the present value of all remaining forecasted dividends.