Gordon Growth Model is a model to determine the fundamental value of stock based on a future series of dividends that grow at a constant rate.
It is based on the future sequence of dividends that mature at a constant rate, provided that the dividend per share is payable in a year, the assumption of the growth of dividend at a constant rate is eternity, the model helps in solving the present value of the infinite series of all future dividends.
It is named after Myron J. Gordon of the University of Toronto, who originally published it along with Eli Shapiro in 1956.
Assumptions of the Gordon Growth Model:
- The company’s business model is stable
- The company grows at a constant, unchanging rate
- The company has stable financial leverage
- The company’s free cash flow is paid as dividends
The Formula for the Gordon Growth Model is :
Intrinsic value (P) = D / (k – G)
D= Expected dividend per share one year from now
k= required rate of return for equity investor
G= Growth rate in dividends.
The Gordon Growth Model values a company’s stock using an assumption of constant growth in payments a company makes to its common equity shareholders. The three key inputs in the model are dividends per share, the growth rate in dividends per share, and the required rate of return. It assumes a company exists forever and pays dividends per share that increase at a constant rate. To estimate the value of a stock, the model takes the infinite series of dividends per share and discounts them back into the present using the required rate of return. The result is the simple formula above, which is based on the mathematical properties of an infinite series of numbers growing at a constant rate.
If the value obtained from the model is higher than the current trading price of shares, then the stock is considered undervalued and vice versa.
Let us take a simple example to illustrate this. Company X is listed at $40 per share. Furthermore, Company X requires a rate of return of 10%. Currently, Company X pays dividends of $2 per share for the following year which investors expect to grow 4% annually. Thus, the stock value can be computed:
Intrinsic Value = 2 / (0.1 – 0.04)
Intrinsic Value = $33.33
This result indicates that Company X’s stock is overvalued since the model suggests that the stock is only worth $33.33 per share.
Advantages of Gordon Growth Model:
1) It is useful for companies that have a great cash inflow and the company has stability with dependable leverage patterns.
2) The valuation can be easily performed since the inputs of data for Gordon’s Growth model are readily available for computation.
3) The model demonstrates a clear relation between valuation and return.
4) The Gordon Growth model has been proven to be favorable to real estate agents and several real estate ventures too.
Limitations of the Gordon Growth Model:
1) The main limitation of the Gordon growth model lies in its assumption of a constant growth in dividends per share. In reality, it is highly unlikely that companies will have their dividends increase at a constant rate.
2) The calculations are basically on future assumptions, which can be subjected to market changes based on the economic conditions and various other factors which contribute to being one of the major disadvantage.
3) Since the model excludes other market conditions such as non-dividend factors, stocks are likely to be undervalued despite a company’s brand and steady growth.
4) Another major issue with this model occurs with the relationship between the discount factor and the growth rate used in the model. If the required rate of return is less than the growth rate of dividends per share, the result is a negative value, rendering the model worthless.
In conclusion in spite of definite success with the companies that have a high cash flow in the company, this model is not suitable for many other companies which are fast growing since it is not flexible enough to include the possible fluctuations in the dividend rates in the future.