Gordon Growth Model

Key Highlights

• The Gordon Growth Model is a valuation approach used to estimate the intrinsic value of a stock.
• It primarily focuses on stocks that pay dividends, incorporating expected future dividend payments into the valuation.
• Developed by economists Myron J. Gordon and Eli Shapiro in the 1950s.
• Provides investors with a tool to assess whether a stock is undervalued or overvalued based on expected future dividends.

Understanding of Gordon Growth Model

We will understand more about what is gordon growth model by these three parameters:

1. Dividend Per Share: The Dividend Per Share is the declared dividend amount for each outstanding equity share, reflecting the anticipated revenue for shareholders on a per-share basis.

2. Dividend Growth Rate: The Dividend Growth Rate signifies the projected annual growth rate for the dividend per share. In the context of the single-stage Gordon Growth Model, this growth rate is assumed to remain constant throughout the valuation period.

3. Required Rate of Return: The Required Rate of Return establishes the minimum hurdle rate necessary for equity shareholders to consider investing in a company. This rate takes into account the average return anticipated from alternative opportunities presenting similar risks in the stock market.

Analysts commonly depend on the Gordon Growth Model when considering companies with consistent and unchanging dividend patterns. It is particularly well-suited for the valuation of mature enterprises operating in well-established markets where the perceived risk is minimal. This model serves as a valuable analytical tool, offering insights into the intrinsic value of stocks, especially in scenarios where dividends play a central role in the overall financial picture.

Presumptions of Gordon Growth Model

The Gordon Growth Model relies on specific assumptions to effectively estimate the value of a stock. These fundamental assumptions encompass several facets:

1. Stable Business Model: The model presupposes a stable business environment devoid of significant operational changes within the company.

2. Consistent Revenue Growth: It assumes a steady influx of revenue from the business, characterized by a constant growth rate over the evaluation period.

3. Balanced Financial Leverage: The company is expected to maintain a balanced level of financial leverage, ensuring a harmonious capital structure.

4. Utilization of Cash Flow: The model operates on the premise that the company allocates its cash flow towards regular dividend payments, emphasizing a consistent distribution to shareholders.

5. Perpetual Existence: Lastly, the Gordon Growth Model assumes the perpetual existence of the company, projecting an enduring lifespan during which it consistently pays a dividend per share that sees continuous increments.

These assumptions collectively underpin the model's applicability and highlight the specific conditions it requires for accurate valuation.

Advantages of Gordon Growth Model

The Gordon Growth Model offers several advantages in the world of stock valuation:

1. Easy to Utilize The Gordon Growth Model boasts a primary advantage in its simplicity. By using just three variables – expected dividend, required rate of return, and dividend growth rate –the GGM offers a straightforward approach to gauging the intrinsic value of a stock. This uncomplicated nature renders the model accessible to a broad spectrum of investors and finance professionals, catering even to those with limited experience in financial analysis.

2. Provides a Sound Estimate of Stock Value When appropriately applied to suitable companies, the Gordon Growth Model can furnish a reasonable estimate of a stock's intrinsic value. By centring its analysis on dividends and their growth, the model underscores the significance of a company's capacity to generate future cash flows.

3. Relevant for Companies Exhibiting Stable Growth Rates The GGM finds particular applicability in valuing companies marked by consistent dividend growth rates. Especially well-suited for mature companies in non-cyclical industries that often manifest steady dividend growth, aligning with the model's assumptions.

The Gordon Growth Model's advantages lie in its simplicity, focus on dividends, suitability for long-term projections, incorporation of growth factors, sensitivity analysis capabilities, and applicability to mature companies.

Disadvantages of Gordon Growth Model

The following factors are the disadvantages of the gordon growth model:

1. Sensitivity to Assumptions: The accuracy of the Gordon Growth Model depends on the precision of its assumptions, particularly the dividend growth rate and discount rate. Minor alterations in these assumptions can result in significant variations in estimated stock value.

2. Neglect of External Factors Affecting Growth Rates: The Gordon Growth Model does not account for external factors that can influence a company's growth rates, such as changes in market conditions, technological advancements, or regulatory shifts. This omission may lead to inaccuracies in valuation estimates.

3. Limited Applicability to Non-Dividend Paying Firms: The model's dependence on dividends for valuation renders it less applicable to firms that do not pay dividends. Companies prioritizing alternative forms of shareholder returns, such as stock buybacks or reinvestments, pose a challenge for accurate valuation using this model.

While the Gordon Growth Model offers valuable insights into stock valuation, investors must navigate its limitations to complement the Gordon Growth Model in a comprehensive investment strategy.

Importance Of Gordon Growth Model

Significant in investment decision-making, the Gordon Growth Model, despite its drawbacks, proves to be a valuable tool. It elucidates the interplay between growth rates, discount rates, and valuation, establishing a transparent connection between valuation and return.

When the intrinsic value derived from the Gordon Growth Model is lower than the prevailing market price, it signals an undervalued share, presenting an advantageous buying prospect for investors. Conversely, if the market price exceeds the intrinsic value calculated by the model, it signifies an overvalued share, prompting caution among investors.

Gordon Growth Model Formula

The equation for the Gordon Growth Model is articulated as follows: Intrinsic Value = D1 / (k - g) Herein, 'D1' denotes the anticipated annual dividend per share for the ensuing year, 'k' signifies the required rate of return or the company's capital cost, and 'g' represents the expected perpetual dividend growth rate.

Example of Gordon Growth Formula

Let's get into an example to enhance our understanding of gordon growth model

Consider Company A, listed on the NSE, with a prevailing market price of Rs. 40 per share. The company currently disburses a dividend of Rs. 2 per share, and investors anticipate a 4% annual growth. With a minimum required rate of return set at 10%, the intrinsic value of the share is calculated as Rs. 2 / (0.1-0.04) = Rs. 33.33.

Comparing this intrinsic value to the market price of Rs. 40 reveals that the security is overvalued. For investors holding the security, this signals an opportune moment to sell, while potential buyers are cautioned by the intrinsic value, serving as a deterrent for acquiring the stock at its current market price.

Conclusion

The Gordon Growth Model is a financial valuation tool that estimates the value of a stock by focusing on dividends and their growth rates. It is mainly used to assess mature companies with stable growth rates by making assumptions about constant dividend growth rates, discount rates, and dividend payout ratios. However, the Gordon Growth Model is still a valuable tool in finance, providing a straightforward approach to estimating stock values. By carefully considering its assumptions, investors can make informed decisions and identify potential market opportunities.