The Gordon Growth Model (GGM) is a financial model used to calculate the intrinsic value of a stock, based on its expected future dividends. GGM calculates the same by discounting its future dividends back to its present value. The Gordon Model is relatively easy to use and provides a simple way to estimate the value of a stock based on its expected future performance.
Gordon Growth Model Formula
The model is used to estimate the intrinsic value of a stock by using the formula which is:
P = D / (r - g)
where:
P = intrinsic value of the stock
D = expected dividend per share
r = required rate of return on the stock
g = expected dividend growth rate
Note: Dividends per share refer to the annual payments made by a company to its common equity shareholders, while the growth rate in dividends per share measures how much the rate of dividends per share increases from one year to the next. The required rate of return is the minimum rate of return that investors are willing to accept when purchasing a company's stock. Investors utilise various models to estimate this rate.
This formula assumes that the dividends will grow at a constant rate indefinitely, which is not always the case. It also assumes that the required rate of return is greater than the expected growth rate of the dividend.
Example of the Gordon Growth Model
As mentioned earlier the Gordon Growth Model is a method used to estimate the intrinsic value of a stock, based on the assumption that a company's dividend payments will grow at a constant rate indefinitely. Here's an example of how the Gordon Growth Model can be used to value a stock:
Let's say that a company currently pays an annual dividend of $2 per share and that the required rate of return on the company's stock is 8%. The company is expected to grow its dividend payments at a constant rate of 5% per year.
Using the Gordon Growth formula, we can calculate the intrinsic value of the stock as follows:
Intrinsic value = D / (r - g)
Where:
D = expected dividend per share
r = the required rate of return
g = the expected growth rate of the dividend payments
Plugging in the numbers, we get:
Intrinsic value = $2 / (0.08 - 0.05)
Intrinsic value = $66.67
So based on the Gordon Growth Model, the intrinsic value of the stock is $66.67 per share.
Importance of the Gordon Growth Model
The Gordon Growth Model (GGM) is a method used to determine the fair value of a stock, regardless of the current market conditions. As we already know this model takes into account factors such as dividend payout and the market's expected returns. If the resulting value from the GGM is higher than the current trading price of a stock, the stock is deemed undervalued and may be considered a buy. Conversely, if the value is lower than the current trading price, the stock may be considered overvalued and thus should be considered for sale.
Limitations of the Gordon Growth Model
While the Gordon Model can be useful, it has several limitations:
Assumption of constant growth:
The Gordon Growth Model assumes that the dividend growth rate will remain constant indefinitely. However, in reality, companies may experience fluctuations in their growth rates due to changes in the market, competition, or other factors.
Limited scope:
The model is best suited for mature companies with stable dividend growth rates. It may not be an appropriate valuation method for companies that are in their growth phase, have volatile earnings, or do not pay regular dividends or any dividends at all.
Sensitivity to inputs:
The model is sensitive to changes in its inputs, including the discount rate and the growth rate. Small changes in these inputs can lead to significant changes in the calculated stock value.
Difficulty in estimating inputs:
Estimating the required inputs for the Gordon Growth Model, such as the growth rate and discount rate, can be challenging. The growth rate, in particular, can be difficult to estimate, and the calculated value can be highly sensitive to small changes in this input.
While the GGM is a popular method of stock valuation, the model does not take into account any factors that may impact the company's ability to pay dividends in the future, such as changes in market conditions or the competitive landscape.
Conclusion
Despite its limitations, the GGM is still a useful tool for investors and analysts looking to estimate the fair value of a stock. By using the model to calculate a stock's intrinsic value, investors can compare that value to the stock's market price and make informed decisions about whether to buy, hold, or sell the stock.
