Gordon Growth Model

Gordon Growth Model
See also
Fundamental analysis Market Risk Premium Preservation Of Capital Asset equity ratio Appraisal right Book-to-Market Ratio Performance shares Money-weighted rate of return Free cash flow yield

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)

References

• Campbell J., Lo A. and MacKinlay A., (2012), The Econometrics of Financial Markets, Princeton University Press, NJ
• Carver L., (2011), Venture Capital Valuation: Case Studies and Methodology, John Wiley & Sons, Hoboken
• CFA Institute., (2016), CFA Program Curriculum 2017 Level II, Tomy 1-6, John Wiley & Sons, Hoboken
• Hitchner J., (2011), Financial Valuation: Applications and Models, John Wiley & Sons, Hoboken
• Reilly R. and Schweihs R., (2004), The handbook of business valuation and intellectual property analysis, McGraw Hill Professional, USA
• Stowe J.,Robinson T., Pinto J. and McLeavey D., (2007), Equity Asset Valuation, John Wiley & Sons, Hoboken
• Viebig J., Poddig T. and Varmaz A., (2008), Equity Valuation: Models from Leading Investment Banks, John Wiley & Sons, Great Britain

Author: Paulina Zając