Gordon Growth Model: Definition, Formula & Example
As an investor, there is a wide range of factors to consider about both current and future investment opportunities. Everything including growth potential, financial stability, and various risk factors are all taken into consideration.
But what can you do if you want to find out the essential value of company stock? In this guide, we’re going to break down the Gordon Growth Model and discuss how it works. We will also cover the formula, its importance, and its pros and cons. Read on to learn more.
Table of Contents
- The Gordon Growth Model is a formula used to determine the intrinsic value of a stock.
- The model accepts that a company will pay out all of its earnings as dividends and that there’s constant dividend growth.
- The Gordon Growth Model is also known as the dividend discount model.
What Is the Gordon Growth Model?
Gordon growth model serves as a valuation model used to determine intrinsic value of company stock. Myron J. Gordon developed the model in 1962 and is also known as the Gordon-Shapiro model.
The model considers a company’s dividend payout ratio, expected growth rate of dividends, and required return rate.
In this guide, we cover the formula for this model. We also look at the pros and cons of the Gordon growth model and more.
Gordon Growth Model Formula
The Gordon growth model formula is:
You can interpret the formula for the Gordon growth model in a few different ways:
Value of Stock = D1 / (r-g)
Value of Stock = Present value of all future dividends / (required return rate – expected dividend growth rate)
Value of Stock = Intrinsic value of stock today + Present value of all future dividends
As you can see, the Gordon growth model is a way to calculate the intrinsic value of a stock by taking into account the present value of future dividends.
The required return rate is the rate of return that an investor requires to invest in a stock. The expected dividend growth rate is a company’s projected dividend growth.
Importance of the Gordon Growth Model
The Gordon Growth Model is an important tool for investors because it provides a way to estimate the intrinsic value of a stock. The model takes into account the expected growth rate of dividends. And this makes it especially useful for investors who are looking for stocks with high dividend growth potential.
The Gordon Growth Model is also important because it is one of the most commonly used dividend discount models. This model helps many investors and analysts value stocks.
Pros and Cons of the Gordon Growth Model
The Gordon Growth Model has a number of advantages, including:
- It is relatively easy to use. This ensures that even new investors can apply the model.
- The model only requires two inputs. One is the dividend per share. The other is the expected growth rate of the dividend.
- You can use it to value a wide range of stocks, including those with different dividend payout ratios and growth rates.
There are also a few disadvantages of the Gordon Growth Model, such as:
- It relies on several assumptions. I.E., that a company will pay out all of its earnings as dividends. Or that the dividend will grow at a constant rate and that the stock holds for an infinite period of time.
- The model doesn’t take into account the effects of inflation. This can lead to an overestimation of the intrinsic value of a stock.
- It doesn’t take into account the timing of dividends. This can also lead to an overestimation of the intrinsic value of a stock.
Despite its limitations, the Gordon Growth Model can be a valuable tool. But it’s important to consider all possible factors. You’ll want to consider the current market price and market conditions.
Is a company more successful during certain business cycles? Perhaps some quarters have a more stable dividend growth rate than others.
Of course, constant growth of dividend is most ideal. Equity shareholders prefer this, as it ensures the best return on equity. And it’s why investors prefer to invest in stable companies.
These companies have strong business models and fewer financial difficulties. As such, current dividends are likely consistent growth. Thus, you can expect a high return rate.
Any time you’re investing, it’s wise to have realistic assumptions. Most times, the earnings growth rate will have some issues. Annual growth will probably fluctuate between negative growth rate and average growth rate.
You can use the Gordon growth model to provide the insight you need to determine future growth periods. Thanks to this multistage growth model, you have a much better chance of knowing the rate of growth.
This is vital for any investment. If there are steady growth rates, there are likely to be long-term growth rates. It’s the unpredictable companies with which you want to use caution.
Example of the Gordon Growth Model
To see how this popular valuation method works, let’s look at an example.
Assume company A is expected to pay a dividend of $1 per share next year. Company A’s required return rate is 10%, and its expected dividend growth rate is 5%. Based on this information, we can calculate the intrinsic value of Company A’s stock using the Gordon Growth Model formula.
Value of Stock = D1 / (r-g)
Value of Stock = $1 / (0.10 – 0.05)
Value of Stock = $2
This means that Company A’s stock is worth $2 per share.
Let’s look at another example.
Assume company XYZ is expected to pay a dividend of $0.50 per share next year. XYZ’s required return rate is 15%, and its expected dividend growth rate is 10%. Based on this information, we can calculate the intrinsic value of XYZ’s stock using the Gordon Growth Model formula.
Value of Stock = D1 / (r-g)
Value of Stock = $0.50 / (0.15 – 0.10)
Value of Stock = $1
This means that XYZ’s stock is worth $1 per share.
Thanks to the Gordon model, you can easily calculate intrinsic stock values.
The Gordon Growth Model is a powerful tool that can be used to estimate the intrinsic value of a stock. However, it is important to remember that the model is a simplification of reality and should serve as a guide rather than a definitive answer.
When using the Gordon Growth Model, it is important to be aware of the limitations of the model and to adjust the inputs accordingly. Doing so will help you to get the most accurate estimate of a stock’s intrinsic value.
FAQs About Gordon Growth Model
To use the Gordon growth method, you will need to know a company’s expected dividend growth rate and its required return rate. You can then use the Gordon growth formula to calculate the intrinsic value of the stock.
The Gordon Growth Model is often used by analysts and investors. The model can be a useful tool for evaluating a stock.
The Gordon Growth Model is a useful tool for valuing businesses. It also teaches you how different factors can affect the value of a company.
The model predicts that a company’s value is equal to the present value of its future cash flows , discounted at the company’s cost of capital. The model also suggests that a company’s growth rate is an important determinant of its value.
The Gordon Growth Model relies on the following assumptions:
- The stock is a non-dividend paying stock, or a stock that does not have a history of dividend payments.
- The model assumes constant growth, which may not be realistic.
- The model does not take into account other factors that can affect a stock’s price, such as earnings, sales, or book value.
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