Gordon Growth Model : A Stock Based on Future Series

The financial worth of an investment depends on its valuation. Additionally, the top rule of investing is to buy low and sell high. However, evaluating the value of an asset is quite challenging. Analysts rely on various methods for valuation developed over the years.

The 'one size fits all’ approach is irrelevant for stock prices valuation. Each method of valuation has specific variables and assumptions. Gordon Growth Model is one such model used to analyze the value of a company depending on its dividend payments.

Gordon Growth Model

Gordon Growth Model is the most straightforward variation of the Dividend Discount Model. It calculates the intrinsic value of a stock based on the present value of future dividends that grow at a constant rate.

The model ignores current market conditions and macroeconomic factors and depends on the company's future dividend payments.

Understanding Gordon Growth Model

There are three inputs for the Gordon Growth Model:

1. Dividend Per Share

   Dividend per share is the amount of dividend declared for each outstanding equity shares It represents expected revenue for shareholders on a per-share basis.

2. Dividend Growth Rate

   Dividend growth rate refers to the projected annual growth rate for dividend per share. In the case of the single-stage Gordon Growth Model, the dividend growth rate is constant.

3. Required Rate of Return

   This is the minimum hurdle rate for equity shareholders to invest in a company. It considers the average return from other opportunities with similar risks in the Stock market.

Typically, analysts use Gordon Growth Model for companies with stable and constant dividends. It is ideal to value mature companies in established markets with minimal risk.

Assumptions of the Gordon Growth Model

Gordon Growth Model assumes the following conditions:

• The company's business model is stable with no significant changes in operations.
• Revenue from business is steady with a consistent growth rate.
• The company has balanced financial leverage.
• The company uses its cash flow for regular dividend payments.
• Dividend payments to common equity shareholders grow continuously.
• Lastly, it assumes that the company lasts forever and pays a dividend per share that increases constantly.

Advantages of the Gordon Growth Model

Gordon Growth Model is a relatively straightforward method to calculate the intrinsic value of a share. It is the easiest to understand and widely used. Comparing companies of different sizes and industries with the Gordon Growth Model is easier.

Additionally, inputs for Gordon Growth Model are readily available or assumed from the company's financial statement or annual report.

Limitations of the Gordon Growth Model

The Gordon Growth Model is subject to various limitations as below:

1. The assumption of constant dividend growth is a primary limitation of the Gordon Growth Model. It is challenging for companies to maintain a continuous growth rate for dividends throughout their life cycle due to market conditions, business cycles, financial difficulties, and related factors.
2. The model is ineffective for companies with high leverage, irregular dividend, and cash flow patterns.
3. If the required rate of return is less than the growth rate, then the intrinsic value will be negative, rendering the model useless. Also, if the needed rate of return is the same as the growth rate, then the value per share approaches infinity.
4. The model is not practical for growing companies without any dividend payment history. Such companies require more assumptions to discount the value of future dividends.
5. Macroeconomic factors, brand image, market perception, and local and geopolitical factors impact a company's share price. However, the Gordon Growth Model does not consider these factors.

Importance of the Gordon Growth Model

Despite the challenges with the Gordon Growth Model, it is a beneficial tool for investment decision-making. It helps determine the relationship between growth rates, discount rates, and valuation. It demonstrates a clear relation between valuation and return.

If the intrinsic value of a share as per the Gordon Growth Model is less than the actual market price, it indicates that the share is undervalued. Thus, it represents a buying opportunity for the investor. On the contrary, if the market price of the share is more than the intrinsic value per the model, then it indicates that the share is overvalued.

Gordon Growth Model formula

The formula for Gordon Growth Model is as below:

Intrinsic Value = D1/(k-g)

where;

'D1' is the annual dividend per share for the following year.

'k' is the required rate of return or the company's capital cost.

'g' is the expected dividend growth rate for perpetuity.

Example of Gordon Growth Model

Let's consider an example to understand the Gordon Growth Model's meaning better.

Company A listed on the NSE, and the current market price is Rs. 40 per share. Currently, it pays a dividend of Rs. 2 per share, and investors expect it to grow at 4% annually. The minimum required rate of return is 10%.

Intrinsic value of the share is Rs. 2 / (0.1-0.04) = Rs. 33.33.

The market price of the share is Rs. 40, whereas the intrinsic value is Rs. 33.33. Thus, the security is overvalued.

For an investor holding the security, it is an opportunity to sell. The intrinsic value acts as a deterrent for an investor who wishes to purchase the stock.

Bottom Line

While the Gordon Growth Model is easy to understand, there are various limitations due to several critical assumptions. It is suitable for stable companies with a history of dividend payments and future growth. A multistage model is more apt for unpredictable companies since it considers more realistic assumptions.