What is the Gordon Growth Model?

The Gordon growth model (GGM) is used to calculate a stock's intrinsic value based on a sequence of dividends that rise at a consistent pace in the future. 

It was first published in 1956 by Professor Myron Gordon of the University of Toronto. This was also where the name was gotten from.

The GGM is a frequently used valuation approach and one of the most widely utilized dividend discount models (DDMs).

It is predicated on the assumption that a business's dividend will rise at a constant rate in perpetuity, providing investors with an existing value of the company based on that future sequence of payments.

Assumptions of the Gordon Growth Model

The Gordon Growth Model presupposes the following:

• The business grows at a steady, consistent rate.

• The company's business model is stable; that is, its operations have not changed much.

• Dividends are paid out of the company's free cash flow.

• The company's financial leverage is steady.

How the Gordon Growth Model is used

The Gordon growth model evaluates a company's stock based on the assumption that payments to common equity shareholders will grow at a constant rate.

Dividends per share (DPS), dividend growth rate, and needed rate of return  (RoR) are the three main inputs in the model.

The GGM seeks to evaluate a stock's fair value regardless of market conditions, taking into account dividend distribution factors as well as the market's predicted returns.

If the model's value is more than the current trading price of shares, the stock is deemed cheap and should be purchased, and vice versa.

Dividends per share are the annual payments a firm provides to its common equity owners, and the dividend growth rate is the percentage increase in dividends per share from one year to the next.

The necessary rate of return is the minimal rate of return that investors are willing to accept when purchasing a company's shares, and it is calculated using a variety of techniques.

The GGM assumes that a corporation survives indefinitely and provides constant dividends per share.

The model takes an infinite number of dividends per share and discounts them back into the present using the needed rate of return to determine the value of a stock.

The calculation is based on numerical principles of an endless series of rising numbers.

P = D1r - g

Where:

P = the current stock price.

D1 = the dividend that the stock is scheduled to pay out in the coming year. Investors must expect that the dividend will increase at the company's historical rate of dividend increases for this calculation. 

r = the required return rate This is the same as the cost of equity capital for the company.

g = the rate at which dividends are predicted to grow. The company's historical average or its long-term dividend growth prediction can be used by investors.

Simply put, the Gordon Growth Model formula is as follows:

Value = stock's next annual dividendrequired return - dividend growth rate

This formula determines the current value of a stock based on predicted future dividends.

Investors can then compare this value to the stock's current market price to see whether it's a good investment.

Limitations of the Gordon Growth Model

The Gordon growth model's basic limitation is that it assumes that dividends per share would grow at a constant rate.

Due to economic cycles and unanticipated financial troubles or achievements, it is extremely rare for corporations to show consistent dividend growth. As a result, the approach is limited to companies with consistent growth rates.

The correlation between the discount factor and the growth rate utilized in the model is the second issue.

The outcome is a negative value, rendering the model useless if the needed rate of return is less than the growth rate of dividends per share.

The value per share approaches infinity if the needed rate of return is the same as the growth rate.

Because the model ignores other market characteristics including non-dividend considerations, stocks are likely to be undervalued regardless of a corporate name and consistent growth.

Variations of the Gordon Growth Model

The GGM comes in a variety of forms. These are some of them:

• The two-stage dividend discount model

• The three-stage dividend discount model

• The H-dividend discount model (H-DDM)

Each of these variants has some characteristics in common with the Gordon Growth Model.

They do not, however, assume a continuous dividend growth rate. Instead, they take into consideration a change in the dividend growth rate, which has an impact on the present value discount factor and, as a result, the stock's projected present value.

The two-stage model, for instance, implies that the dividend grows at a constant rate during the first part of its life before changing to a different rate for the rest.

A third phase of dividend increase is also accounted for in the three-stage model. 

The H-DDM, on the other hand, contains both starting and terminal dividend growth rates.

PROs and CONs of the Gordon Growth Model

PROs

• It can be used as a starting point for more complex dividend-based stock valuation models like the two- and three-stage models.

• It aids investors in determining the worth of a company's stock.

• It's best for corporations with a long track record of increasing dividends.

• It is not difficult to use.

CONs

• It is not appropriate for companies that do not pay dividends or do not increase their payouts consistently. The GGM, for example, is rarely used to value speculative, high-growth stocks.

• It assumes that a company's dividend will continue to grow at the same rate indefinitely.

• The link between the discount rate (cost of equity capital) and the dividend growth rate may have some potential difficulties. 

The model may produce a negative number if the needed rate of return is less than the dividend growth rate. If they're the same, though, the value of a corporation is set to infinite.