Gordon Growth Model

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Gordon Growth Model
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The Gordon Growth Model (GGM) is also kenned as the dividend discount model (J.Viebig, T. Poddig, and A.Varmaz 2008, p.164). Gordon's growth model is the simplest practical application of discounted dividend pricing. This model is appropriate for the capital valuation of dividend-paying companies when its key assumption of a stable future dividend rate and profit growth is met. Broad stock market indices of developed markets often quite well meet the model's conditions. As a result, analysts used it to assess whether the stock market was fairly priced or not and to assess the risk premium for shares associated with current market levels. In the multi-stage models, the Gordon Growth Model was often used to the model of the last stage of growth, when a company achieved high growth and the growth rate drops to long-term sustainable levels matures. According to the CFA Institute:" The Gordon growth model is a single-stage DDM because all future periods are grouped into one stage characterized by a single growth rate." (CFA Institute 2017, chap.4.8)

Formula of the Gordon Growth Model

The formula of the Gordon Growth Model is presented as:

\(P=\frac{D}{k-g}\)

  • g= growth rate (%)
  • k= the expected return (%)
  • D= dividend dollars
  • P= stock price

This model can be rearranged to clarify for the expected return (k):

\(k=\frac{D}{P}+{g}\)

  • k=dividend growth+dividend yield (J.Hitchner 2011, p.201).

Weaknesses and strengths of the Gordon Growth Model

The Gordon Growth Model, like any other, has advantages and disadvantages. According to J.Stowe, T.Robinson, J.Pinto, and D.Mcleavey, in this case, the strengths prevail, viz:"

  • The Gordon growth model is often useful for valuing stable-growth, dividend-paying companies.
  • It is often useful for valuing broad-based equity indexes.
  • The model features simplicity and clarity; it is useful for understanding the relationships among value and growth, the required rate of return, and payout ratio.
  • It provides an approach to estimating the expected rate of return given efficient prices( for stable-growth, dividend-paying companies)[...]the Gordon growth model can readily be used as a component of more-complex DDMs, particularly to model the final stage of growth." (J. Stowe, T.Robinson, J.Pinto and D.McLeavey, 2007, p.73-74)

This model has also weaknesses according to J.Stowe, T.Robinson, J.Pinto, and D.McLeavey":

  • Calculated values are very sensitive to the assumed growth rate and the required rate of return.
  • The model is not applicable, in a practical sense, to non-divided-paying stocks.
  • The model is also inapplicable to unstable-growth, dividend-paying stocks." (J. Stowe, T.Robinson, J.Pinto and D.McLeavey, 2007, p.73-74)

Examples of Gordon Growth Model

  • The Gordon Growth Model is a formula for valuing a stock based on the dividend yield and the expected growth rate of the stock's dividend. For example, a company that pays a dividend of $1 per share and is expected to grow that dividend by 5% each year can be valued using the Gordon Growth Model. If the required rate of return is 10%, then the stock is worth $20.
  • Another example of the Gordon Growth Model is when an investor is evaluating a stock with a dividend yield of 3%, and the expected growth rate of the dividend is 4%. If the investor's required rate of return is 10%, then the stock is worth $75.
  • A third example of the Gordon Growth Model is when a company has a dividend yield of 5% and an expected dividend growth rate of 10%. If the investor's required rate of return is 8%, then the stock is worth $125.

Advantages of Gordon Growth Model

The Gordon Growth Model is a valuation technique that is used to determine the intrinsic value of a share. It is based on the assumption that a company’s dividends will grow at a constant rate. Here are some advantages of the Gordon Growth Model:

  • It is easy to use and understand. The model only requires a few inputs, such as the dividend growth rate, dividend per share, and the required rate of return.
  • It is a relatively accurate way to value a stock. It takes into account the expected future dividends in the calculation and assumes that the dividends will grow at a constant rate.
  • It takes into account the time value of money. The model assumes that an investor will receive the dividends in the future and thus considers the expected return over time.
  • It allows investors to compare the potential return of different stocks. By using the model, investors can calculate the intrinsic value of a stock and compare it to the market price to determine if the stock is overvalued or undervalued.
  • It is useful in estimating the value of a stock as part of a merger or acquisition. The model can be used to estimate the value of a company’s stock in the event of a merger or acquisition.

Limitations of Gordon Growth Model

The Gordon Growth Model is a widely used method of valuing a stock, but it has several limitations. These include:

  • Non-constant dividend growth - The Gordon Growth Model assumes that the dividend growth rate is constant, but this is often not the case in real-world situations.
  • Ignores risks - The model does not take into account any associated risks when calculating the stock's intrinsic value.
  • Assumes reinvestment - The model assumes that all dividends are reinvested and not consumed.
  • Assumes efficient markets - The model assumes that the markets are efficient and that the current stock price accurately reflects the stock's intrinsic value.
  • Ignores inflation - The model does not account for inflation, which can have an impact on the stock's intrinsic value.
  • Limited to dividends - The model is limited to valuing stocks based on dividend payments and does not take into account other sources of cash flow, such as capital gains.

Other approaches related to Gordon Growth Model

The Gordon Growth Model is a popular approach to valuing a company's stock, but there are a number of other approaches that can be used to determine the value of a company's stock. These alternatives include:

  • The Discounted Cash Flow (DCF) Approach: This approach uses the future cash flows of a company and discounts them back to the present day to determine the value of the stock.
  • The Relative Valuation Approach: This approach compares the value of a company's stock to similar companies in the same industry to determine an appropriate value.
  • The Earnings Multiples Approach: This approach uses the company's earnings as a basis for valuing the stock and compares it to the market average to determine the value.

In summary, the Gordon Growth Model is a popular approach to valuing a company's stock, but there are several other approaches to consider, including the Discounted Cash Flow, Relative Valuation, and Earnings Multiples approaches.

References

Author: Paulina Zając