Gordon Growth Model
The Gordon Growth Model (GGM) helps an investor to determine the intrinsic value of a stock based on the constant rate of growth of its future dividends. Put simply, the Gordon Growth Model uses a company’s rate of return and its dividend growth to estimate the fair price of its stock.
Gordon Growth Model is based on the Dividend Discount Model (DDM) and was developed by Professor Myron J. Gordon of the University of Toronto in the late 1950s. Under the DDM, estimating the future dividends of a company could be a complex task since dividend payouts of companies may vary due to other factors such as market conditions, profitability, and so on. The GGM differs from the DDM in that it assumes a constant rate of growth of dividends.
Gordon Growth Model Formula
- P = Fair Value of the stock
- D1 = Expected dividend amount for next year
- r = Cost of Equity or the required rate of return
- g = Expected growth rate of dividends (assumed to be constant)
The current dividend payout (D0) can be found in the Annual Report of a company. To calculate the next year’s dividend payout (D1), we need to multiply the current year’s dividend by the expected future growth rate of dividends (g)
The required rate of return or the cost of equity is what the investors expect to receive for investing in the stock. We can estimate this rate using various models, the most popular of which is the Capital Asset Pricing Model (CAPM)
The dividend growth rate can be estimated by multiplying the Return on Equity (ROE) by the Retention Ratio.
Return on Equity can be calculated by dividing the net income of the company by the shareholder’s equity.
While net income can be found in the company’s Income statement, Shareholder’s Equity is part of the balance sheet of the company.
The retention Ratio is the opposite of the dividend payout ratio and is basically the proportion of net income that is plowed back into the business as retained earnings. This can be calculated by dividing the retained earnings of the company by its net income.
Retained Earnings can be found on the balance sheet of the company while net income can be taken from its income statement
Gordon Growth Model Example
Company A’s share is trading at $53 per share. It has paid out a dividend of $2 per share in the current financial year and the expected dividend growth rate is 5% every year. Investors expect a minimum of 8% return every year from the company. Calculate the intrinsic value of Company A’s stock using the Gordon Growth Model.
Let’s start by calculating the dividend for next year (D1). We know that the current year’s dividend (D0) is $2 and the expected dividend growth rate (g) is 5%.
Now that we have estimated the value of D1, we can use the GGM formula to determine the intrinsic value of Company A’s stock:
So, according to the Gordon Growth Model, the intrinsic value of the stock is $70. Since the share is currently trading at $53 per share, as per GGM, the stock is undervalued and investors can consider buying into it.
Gordon Growth Model Analysis
GGM is very useful in analyzing the value of stable companies with good cash flow and constant dividend growth rates. But in reality, it is very difficult for companies to achieve a constant growth rate due to various extraneous factors that affect their profitability and growth.
Also, there are quite a few companies that pay little or no dividends at all despite making regular profits. Instead, they reinvest all or some of the earnings back into the company to sustain or increase its future growth. In such companies, it becomes quite tricky to use GGM to calculate the fair value of the stock since the investor has to first estimate the dividend for the company (despite the absence of the payout) and then calculate the fair value using the model. Obviously, this calls for a whole lot of assumptions in the model which will further reduce its accuracy. Instead, one can use other criteria such as earnings per share to calculate the fair value of the stock.
The other more important issue with GGM is the relationship between the other two variables in the formula – the growth rate and the required rate of return. GGM assumes that the cost of capital is always higher than the growth rate. Though such an assumption always works in the investor’s favor, one cannot assume that it is going to be the case at all times.
- If at the growth rate exceeds the required rate of return, the model becomes useless since it will produce a negative value for the stock price, which obviously, is unrealistic.
- Similarly, if the growth rate equals the required rate of return, the denominator becomes zero which again renders the model worthless since the intrinsic value of the stock will approach infinity.
Gordon Growth Model Conclusion
With all its limitations, the Gordon Growth Model is still a useful valuation tool since it demonstrates the relationship between the fair value of the stock in relation to its return (in terms of dividend). To sum up,
- GGM is based on the Dividend Discount Model of valuation but assumes a constant growth rate for dividends
- It uses future dividends, growth rate, and required rate of return to determine the intrinsic value of a stock
- GGM is useful for stable companies with a constant growth rate and free cash flow (that is fully paid off as dividends)
- GGM is not useful when the growth rate exceeds or is equal to the required rate of return since the model will produce a negative value for the stock price or the stock price will approach infinity, respectively.
Gordon Growth Model Calculator
You can use the Gordon Growth Model calculator below to find the GGM stock price by entering the required numbers.
1. What is Gordon growth model?
The Gordon growth model is a method of valuing stock prices that are dependent on dividend payments. It works by determining the value of dividends paid out next year, based on current dividends and forecasted future rates of growth.
2. How is the Gordon growth model calculated?
The equation is:
P = D1 / r−g
P = Fair Value of the stock
D1 = Expected dividend amount for next year
r = Cost of Equity or the required rate of return
g = Expected growth rate of dividends (assumed to be constant)
3. How accurate is the Gordon growth model?
The Gordon growth model is an approximation that only provides the correct value if dividends are expected to grow at a constant rate.
This can be difficult for companies with multiple external factors affecting their profitability and stock price, volatility in the market that affects dividends, or changes in management policy that affect profits.
4. What is K in the Gordon growth model?
K represents the required rate of return and is used in the same way as it is in all discounted cash flow models.
5. Why is the growth model important?
The Gordon growth model is an important part of discounted cash flow valuation, as it allows you to determine the intrinsic value of a stock through its dividend. It also allows investors to compare that dividend against other stocks.