Gordon Growth Model

The Gordon Growth Model is a variant of the Dividend Discount Model that calculates the present value of a stream of future dividends by assuming a constant rate of dividend growth in perpetuity. It is used to estimate the intrinsic value of stocks and is generally applicable to companies with stable growth in dividends per share.

The model takes into account the time value of money and the expected growth rate of dividends to calculate future cash flows. The model can also be used to compare different stocks and assess the cost of capital for the company.

The model is based on the assumption that the dividend payout ratio remains constant. This means that the company will continue to pay out the same percentage of its earnings as dividends in the future. This assumption is useful in determining the valuation of a company but it also has its limitations.

For example, the model doesn’t take into account external factors such as changes in the economic environment, which can affect the future cash flows. In addition, the model does not consider other factors such as the company’s management team, which can have a significant impact on future performance.

Despite its limitations, the Gordon Growth Model remains a useful tool for investors to analyze and compare stocks. It provides a simple and reliable way of estimating the intrinsic value of a stock, which can be used to make informed decisions.

How to Calculate Gordon Growth Model

By utilizing three variables, a calculation of a stock’s fair value can be made. This is achieved through the Gordon Growth Model (GGM), which considers Dividends Per Share (DPS), Dividend Growth Rate (g), and Required Rate of Return (r). Here is how it works:

1. Calculate the present value of the DPS, which is equal to the DPS divided by the required rate of return.
2. Calculate the future value of the DPS by multiplying the present value of the DPS by one plus the dividend growth rate.
3. Calculate the fair value of the stock by dividing the future value of the DPS by one minus the required rate of return.
4. Repeat steps one through three for the next DPS to calculate the fair value of the stock.

The GGM is a reliable way to calculate the fair value of a stock, taking into account the current dividend, dividend growth rate, and required rate of return. As a result, this model provides investors with an accurate assessment of the stock’s true value.

Advantage of Gordon Growth Model

Utilizing three vital variables, the Gordon Growth Model provides investors with a reliable assessment of a stock’s true value. The model is based on the assumption that a company’s future dividends will grow at a constant rate. To calculate the value of a share, the model takes into account the current dividend per share, the current rate of return, and the expected growth rate of dividends.

The advantage of the GGM is that it provides investors with a relatively simple and accurate tool to estimate the true value of a company’s stock.

The GGM is best suited for mature companies with consistent profitability and dividend policies since the single-stage model is simple but less accurate for high-growth companies with changing factors. Furthermore, the GGM is a useful tool for investors to compare the value of stocks between different companies. By evaluating the dividends per share, rate of return, and expected growth rate of dividends, the GGM enables investors to evaluate the relative value of a company’s stock.

The Gordon Growth Model offers a number of advantages to investors. It is relatively simple to calculate and provides investors with an accurate assessment of a stock’s true value. It is also useful for comparing the value of stocks between different companies. By taking into account the current dividend per share, rate of return, and expected growth rate of dividends, the model enables investors to make informed decisions when selecting stocks.

Disadvantage of Gordon Growth Model

Despite its advantages, the Gordon Growth Model has several drawbacks that investors should consider before using it.

Firstly, the model assumes that dividends will continue to grow at the same rate indefinitely, which may not be the case. Companies and their business models can undergo adjustments and face new risks over time, meaning that the GGM may not provide an accurate representation of future dividends.

Furthermore, the model is most suitable for mature, established companies with consistent dividend growth. Underperforming companies may issue large dividends despite deteriorating financials, so investors should be aware of this.

Lastly, the GGM does not consider fluctuations in the stock market, which can have a significant effect on the value of a company’s stock. Therefore, investors should take into account the potential risks associated with the GGM before investing.

Conclusion

The Gordon Growth Model is a widely used tool for evaluating a stock’s intrinsic value. It provides a simple and effective method for calculating future dividends and capital appreciation.

Although the model is useful for estimating future dividends, it does not take into account other factors, such as expected changes in the market or the stock’s underlying fundamentals. Therefore, it is important to consider other factors when evaluating a stock’s intrinsic value.

Ultimately, the Gordon Growth Model provides a useful tool for estimating a stock’s intrinsic value, but should not be the only factor considered when making an investment decision.