Fundamentals of the Gordon Growth Model
Gordon Growth Model Assumptions
The Gordon Growth Model (GGM), also known as the dividend discount model, is a staple in finance and is used to determine the intrinsic value of a stock based on a series of future dividends. It was popularized by Myron J. Gordon in the 1960s. The model makes a few key assumptions:
- Dividends grow at a constant rate, which is expected to be steady and stable over time.
- The dividend growth rate is less than the required rate of return for the stock.
- The stock is held by mature companies that can maintain stable growth rates.
These assumptions ensure the framework for the GGM applies to the companies it aims to evaluate.
Explaining the Gordon Growth Model Formula
The GGM formula is designed to calculate the intrinsic value of a stock based on the net present value of its future dividends. The formula can be expressed as follows:
Stock Price = D1 / (Required Rate of Return - Dividend Growth Rate)
In this equation, D1 represents the expected dividends per share for the next year, the Required Rate of Return is the minimum return an investor expects to receive from the stock, and the Dividend Growth Rate is the constant rate at which dividends are expected to grow.
The GGM formula essentially discounts the future dividends to their present value to determine the stock’s intrinsic value.
Connection Between Dividends and Stock Price
The GGM establishes a strong link between dividends, stock price, and company earnings. When a company pays its shareholders dividends, it essentially shares a portion of its earnings. These dividends serve as a return on investment for the stockholders.
The annual dividend is an essential element of the GGM, which grows constantly. As dividends per share and the expected dividend growth rate increase, the stock price is also expected to rise. Conversely, a decrease in dividends can result in a lower stock price.
Applying the Gordon Growth Model
The Gordon Growth Model (GGM) is a valuable tool for investors who aim to evaluate a stock based on its intrinsic value. This model is primarily used to determine a stock’s fair value and involves considering factors such as future dividends and the cost of equity. This section will discuss how to apply the Gordon Growth Model and understand the concepts of overvalued and undervalued stocks.
Calculating the Intrinsic Value of a Stock
To calculate the intrinsic value of a stock using GGM, three variables are required: the current dividend per share, the constant dividend growth rate, and the required rate of return (cost of equity) on the stock.
The formula for GGM is as follows:
Intrinsic Value = (Current Dividend * (1 + Dividend Growth Rate)) / (Required Rate of Return - Dividend Growth Rate)
For example, suppose an investor is evaluating a stock with a current dividend of $2, a dividend growth rate of 5%, and a required rate of return of 10%. Applying the GGM formula, the intrinsic value of the stock would be:
Intrinsic Value = (2 * (1 + 0.05)) / (0.10 - 0.05) = $42
Understanding Overvalued and Undervalued Stocks
An investor can use the intrinsic value calculated through GGM to decide whether a stock is overvalued, undervalued, or fairly valued. If the stock’s market value is higher than its intrinsic value, it is considered overvalued. On the other hand, if the market value is lower than the intrinsic value, the stock is undervalued.
Using the previous example, if the stock’s current market price is $50, it is overvalued since its intrinsic value is $42. Conversely, the stock is undervalued if the market price is $35.
Pros and Cons of the Gordon Growth Model
The GGM has its advantages and disadvantages. Advantages include its simplicity and straightforward approach to calculating the intrinsic value of a stock. However, it also has some disadvantages, such as assuming that both the dividend growth rate and the required rate of return are constant, which may not always be accurate in reality.
Additionally, GGM relies on future dividend payments, making it less suitable for companies that do not pay dividends or have an erratic dividend payout history. In such cases, alternative methods, such as the discounted cash flow model or free cash flow valuation, may be more appropriate for investors to use when determining the intrinsic value of a stock. Nonetheless, the Gordon Growth Model is a helpful starting point for investors who want to analyze the value of dividend-paying stocks.
Limitations and Variations of the Gordon Growth Model
Drawbacks of the Gordon Growth Model
The Gordon Growth Model (GGM) is a widely used method for valuing stocks but has some significant limitations. One of the main drawbacks of the GGM is its assumption of constant dividend growth, which is rare for companies. This could lead to inaccurate estimations, especially for companies in different industries and sizes.
Another limitation is the model’s sensitivity to the growth rate estimate. A small change in the estimate could lead to drastically different valuations. In some cases, the GGM may also produce a negative value, which can be difficult to interpret in the context of stock valuation.
The GGM may not be suitable for companies with high growth, as its simplicity does not account for business cycles, volatility, and other factors that could impact a company’s long-term growth. Additionally, the model does not consider intangible assets such as brand loyalty, patents, and other factors that could contribute to a company’s overall value.
Variations: Multi-Stage Growth Model
To address the limitations of the GGM, the Multi-Stage Growth Model is used as an alternative. This model accounts for different growth stages within a company’s life cycle, allowing investors to estimate a stock’s value better, especially for businesses in diverse industries and sizes.
The Multi-Stage Growth Model typically has three stages:
- High Growth Stage: This stage assumes a high growth rate for a specific period and calculates the dividends’ net present value (NPV) for that period.
- Transition Stage: The growth rate starts to decline during this stage as the company moves from a high-growth phase to a mature industry growth rate.
- Mature Growth Stage (Terminal Value): This stage assumes a constant growth rate, similar to the GGM, and calculates the dividends’ net present value (NPV) for perpetuity.
By considering different growth rates and stages, the Multi-Stage Growth Model offers a more comprehensive approach to valuing stocks than the GGM, making it particularly suitable for evaluating companies with varying growth rates, industries, and sizes.