What is the Gordon Growth Model (GGM)?
A stock’s intrinsic value is predicated on a future sequence of dividends that grow constantly using the Gordon growth model (GGM). This is a simple and standard dividend discount model (DDM) variation. The GGM calculates the present value of infinite dividends, assuming a constant growth rate.
Companies with consistent dividend-per-share growth rates utilize the model because it implies a constant growth rate.
Gordon Growth Model Formula
The Gordon growth model formula uses the mathematical features of an endless sequence of integers expanding at a constant pace. The model relies on three inputs: dividends per share (DPS), dividend growth rate, and the necessary rate of return (ROR).
P=D1/(r−g)
Where:
P = Current stock price
g = expected constant growth rate for infinite time variables.
The rate of return (r) is the firm’s constant cost of equity capital.
The value of next year’s dividends is D1.
Gordon Growth Model Importance
The GGM calculates a company’s fair value using dividend payment considerations and predicted returns, regardless of market conditions. When the model value exceeds the actual trading price, the stock is deemed cheap and suitable for purchase, and vice versa.
Company dividends per share are annual payments to familiar equity owners, whereas the dividend growth rate is the rise in dividends per share from year to year. The necessary rate of return is the minimal rate of return investors will tolerate when buying a company’s shares. Multiple methods estimate this rate.
Gordon Growth Model assumptions
The Gordon growth model assumes consistent dividend growth for familiar equity owners, valuing a company’s shares. The GGM implies a corporation survives forever and provides continual dividend raises per share.
The model reduces the infinite series of dividends per share to the present, using the needed rate of return to determine a stock’s intrinsic value.
Gordon Growth Model limitations
Its fundamental drawback is the Gordon growth model’s premise of continuous dividend per share growth. Companies seldom see consistent dividend increases owing to business cycles and unanticipated financial challenges or accomplishments. Thus, the approach only applies to stable-growing enterprises.
Second, the discount factor and model growth rate connection are problematic. The model is meaningless if the needed rate of return is less than the dividend per share growth. If the needed rate of return matches the growth rate, the share price approaches infinity.
Gordon Growth Model example
Take a $110-per-share corporation as an example. This corporation requires an 8% minimum rate of return (r) and will pay a $3 dividend per share next year (D1), predicted to rise 5% yearly (g).
Calculating the stock’s intrinsic value (P):
P=$3.08−.05=$100P=.08−.05$3=$100
Gordon’s growth model says the shares are $10 overdue.
Gordon Growth Model: Pros and Cons
Pros
- The GGM formula is widely preferred for determining intrinsic value and is simple to comprehend.
- The model calculates stock value without market circumstances, simplifying the process.
- This simple method lets you compare firms of different sizes and sectors.
Cons
- The Gordon growth model overlooks non-dividend elements like brand loyalty, customer retention, and intangible assets that can increase a company’s worth.
- This implies a steady dividend growth rate for a corporation.
- This method solely values dividend-paying equities, excluding most growth firms.
Gordon Growth Model (GGM): What Does It Say?
To determine a stock’s fair value, the Gordon growth model considers dividend payment considerations and predicted returns, regardless of market conditions. If the GGM value exceeds the stock’s market price, buy it. Overvalued stocks should be sold if their value is lower than their market price.
What Are Gordon Growth Model (GGM) Inputs?
The GGM uses dividends per share (DPS), DPS growth, and the necessary rate of return. The DPS growth rate is the annual dividend increase, whereas DPS is the annual dividend payments to familiar stock owners. The necessary rate of return is the minimal rate at which investors will buy shares.
What Are Gordon Growth Model (GGM) Drawbacks?
The GGM’s biggest drawback is assuming a steady dividend per share growth. Companies seldom raise dividends consistently owing to business cycles and unanticipated financial triumphs. This limits the strategy to firms with predictable dividend-per-share growth. Another problem is the discount factor-growth rate link in the model. The model is meaningless if the needed rate of return is less than the dividend per share growth. If the needed rate of return matches the growth rate, the share price approaches infinity.
The Verdict
Using the Gordon growth model to calculate a company’s stock value is popular. The model’s assessment of a company’s share price should be greater than its market price, indicating an undervalued stock. Sell the stock if the GGM result is lower than the market price.
The Gordon growth model assumes a steady dividend increase, which is a drawback. This only works for stocks of certain firms with dividends that fit that assumption. If the formula’s needed rate of return is less than the dividend growth rate, the result is negative and useless.
Conclusion
- The Gordon growth model (GGM) calculates corporate stock value.
- It values a company’s shares as if they exist forever, and dividends rise constantly.
- The GGM discounts an endless sequence of dividends per share to the present using the needed rate of return.
- Variation of the dividend discount model
- The GGM assumes continual dividend growth, making it excellent for stable, growing firms.
