Introduction to the Gordon Growth Model
The Gordon Growth Model (GGM) offers an intuitive formula to derive the intrinsic value of stocks, centered around an infinite series of dividends growing at a constant rate. Ideal for companies featuring stable growth rates, the GGM is a simplified and popular version of the dividend discount model (DDM).
Key Highlights
- Uses intrinsic value to assess a company’s stock.
- Assumes perpetual existence and steady dividend growth.
- Ideal for firms with predictable and consistent dividend increases.
Gordon Growth Model Formula and Calculation
The three fundamental components of the formula are dividends per share, the constant dividend growth rate, and the required rate of return (RoR). Here’s the GGM formula:
\begin{aligned}
P = \frac{ D_1 }{ r - g }
\textbf{where}, \\
P = \text{Current stock price} \\
D_1 = \text{Value of next year’s dividends} \\
g = \text{Constant dividend growth rate} \\
r = \text{Required rate of return} \\
\end{aligned}
Importance of the Gordon Growth Model
The GGM helps calculate a stock’s intrinsic value irrespective of market movements. By aligning computed value with current market price, investors can discern whether a stock is undervalued (potential buy) or overvalued (consider selling).
Advantages and Limitations
Benefits
- Simplifies intrinsic value estimation.
- Consistent with Dividend Discount Model fundamentals.
Drawbacks
- Assumes constant dividend growth, which is rarely realistic due to fluctuating business conditions.
- Can produce unreliable values when required rate of return meets or falls below the dividend growth rate.
Practical Example
Consider a stock priced at $110, requiring an 8% return (r). Expected dividends next year (D1) are $3, growing at 5% annually (g). Calculation:
\begin{aligned}
p = \frac{\$3}{.08 - .05} = \$100
\end{aligned}
This scenario suggests the stock is $10 overvalued.
Conclusion: Using the Gordon Growth Model Efficiently
The Gordon Growth Model stands out as a valuable tool to unveil a stock’s intrinsic value, fostering informed buy or sell decisions. However, investors should be mindful of its limitations, particularly the constant growth assumption.
By leveraging the GGM wisely, investors can augment their stock market strategies, ensuring sound and judicious investment decisions.
Related Terms: Dividend Discount Model, Rate of Return, Intrinsic Value, Dividends per Share.
References
- Stern School of Business, New York University. “Dividend Discount Models”, Pages 1-5.
- Stern School of Business, New York University. “Dividend Discount Models”, Page 11.
