Gordon Growth Model plays an important role in determining the intrinsic value of a stock based on a future series of dividends that grow at a constant rate.
2. Meaning and Definition
The Gordon Growth Model – otherwise described as the dividend discount model – is
a stock valuation method that calculates a stock’s intrinsic value. Therefore, this
method disregards current market conditions. Investors can then compare companies
against other industries. The Gordon Growth Model (GGM) is used to determine the
intrinsic value of a stock based on a future series of dividends that grow at a constant
rate. It is a popular and straightforward variant of the dividend discount model
(DDM). The GGM assumes the dividend grows at a constant rate in perpetuity and
solves for the present value of the infinite series of future dividends. Because the
model assumes a constant growth rate, it is generally only used for companies with
stable growth rates in dividends per share. es using this simplified model.
3. Who developed Gordon Growth Model?
The equation most widely used is called the Gordon growth model (GGM).
It is named after Myron J. Gordon of the University of Toronto, who
originally published it along with Eli Shapiro in 1956 and made reference to
it in 1959.
4. Formula and Calculation of the Gordon
Growth Model
P= D1/(r-g)
P= Current stock price
g= Constant growth rate expected for dividends, in perpetuity
r= Constant cost of equity capital for the company (or rate of return)
D1= Value of next year’s dividends
5. Assumptions of Gordon Growth Model
• The company’s business model is stable; i.e. there are no significant changes
in its operations
• The company grows at a constant, unchanging rate
• The company has stable financial leverage
• The company’s free cash flow is paid as dividends
6. Advantages of Gordon Growth Model
• The Gordon Growth Model is especially useful for companies that have a
great cash inflow and the company has stability with dependable leverage
patterns.
• The valuation can be easily performed since the inputs of data for Gordon’s
Growth model are readily available for computation.
• The Gordon Growth model has been proven to be favorable to real estate
agents and several real estate ventures too.
7. Disadvantages of Gordon Growth Model
• The Gordon Growth Model is especially useful for companies that have a
great cash inflow and the company has stability with dependable leverage
patterns.
• The valuation can be easily performed since the inputs of data for Gordon’s
Growth model are readily available for computation.
• The Gordon Growth model has been proven to be favorable to real estate
agents and several real estate ventures too.
8. Uses
• 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
(DPS), the growth rate in dividends per share, and the required rate of return
(RoR).
• Dividends per share represent the annual payments a company makes to its
common equity shareholders, while the growth rate in dividends per share is
how much the rate of dividends per share increases from one year to
another. The required rate of return is a minimum rate of return investors
are willing to accept when buying a company's stock, and there are multiple
models investors use to estimate this rate.
9. It is only used for companies with stable growth rates in dividends per share.
To apply the Gordon growth model, you must first know the annual dividend
payment and then estimate its future growth rate. Most investors simply look
at the historic dividend growth rate and make the assumption that future
growth will be comparable to past growth
