Gordon Growth Model

What is the Gordon Growth Model?

The Gordon Growth Model (GGM) is a stock valuation method used to determine the intrinsic value of a stock by considering the sum of the present value of its future dividend payments. This method was published by Professor Myron J. Gordon, to value stocks or businesses. 

The GGM focuses on the intrinsic value of the stock, assuming a constant rate of growth for future dividends, and ignores the current state of the market. It is a specific application of the Dividend Discount Model (DDM).

Investors often wonder if they are overpaying when buying shares of a company. Therefore, they may use valuation methods such as the Gordon Growth Model to determine the well-being of their investment.

Principally, the GGM assumes an infinite series of future dividends growing at a constant rate in perpetuity. It is most effective for businesses with fixed dividend growth rates.

Gordon Growth Model Explained

The Gordon Growth Model calculates the present value of a stock price based on an infinite stream of future dividends. The variables used in GGM are the dividend per share (DPS), the required rate of return (r), and the dividend growth rate per share (g).

This model is easy to use because it involves only three variables, which are typically found in a company’s financial reports.

GGM attempts to value a stock based on expected market returns and dividend payouts, helping investors make informed decisions when comparing stocks. If the value obtained from the GGM is lower than the market price of the stock, the stock is considered overvalued. Conversely, if the value is higher than the current market price, the stock is considered undervalued.

Companies are recommended to use this model when dividends grow at a constant rate, earnings keep pace with dividends, and the required rate of return is higher than the growth rate. However, companies with high growth and changing dividend payouts should avoid using this model.

The GGM does not consider the market value of the company or the current economic conditions; it only considers the growth of dividend payments. Thus, the model can be used for companies of various sizes.

The multistage dividend discount model, based on the Gordon Growth Model, includes the two-stage and three-stage models.

Nevertheless, based on the Gordon growth model there is the multistage dividend discount model, which includes the two-stage, and three-stage models.

The two-stage Gordon Growth Model is used when a company has unstable growth in the first stage and stable growth in the second stage. The formula is similar to the GGM but includes the growth rate (g) for the second stage.

The three-stage model involves an initial period of higher growth, followed by a phase of positive or negative growth, before stabilizing at a constant growth rate for the company's lifetime.

Gordon Growth Model Formula

The model is computed as follows: 

P = D1/(r–g)

Where:

• P = The present value of the stock
• D1 = The value of next year’s expected dividends
• r = required rate of return (The cost of equity capital ke of the company)
• g = expected growth rate

Ke =Rf +i(E(Rm)-Rf)

Where:

• Rf = the base return (risk-free rate)
• i = measure of stock risk 
• (E(Rm)-Rf) = is the market risk premium

Dividends per share are the yearly payments made by a corporation to its common equity holders, whereas the required rate of return is the minimum return that an investor anticipates getting on their investment. 

The expected growth rate is the amount by which the rate of dividends per share increases each year.

To clarify this formula:

• When the growth rate increases, the denominator will decrease, and as a result, the present value will increase, and vice versa. The rise in growth indicates an increase in dividends paid.
• When the required rate of return increases, the denominator will increase. As a consequence, the present value of the stock will decrease, and the other way around.
• When the DPS is unknown, the best way to compute it is by multiplying the current dividend by the growth rate, D0(1+g).

In this situation, the formula that is to be used is the following:

P = D0(1+g)/(r–g)

Example of the Gordon Growth Model

Overvalued stock example

To illustrate, let’s assume a company’s stock is listed at $220 per share. The company’s required rate of return (r) is 7%, and it is willing to pay a $4 dividend next year, while investors expect the growth (g) to be 5% annually.

The intrinsic value is computed as follows:

P = $4/(7%-5%) = $200 

The above calculation indicates that the present value of the stock equals $200, while the market value of the stock is $220. 

This means that the stock is trading above the intrinsic value with a $20 difference. Therefore, considering the Gordon Growth Model, the stock is considered overvalued.

Undervalued stock example

Let’s assume a company stock is currently trading for $70 per share. The company’s required rate of return (r) is 8%, and the dividend per share (DPS) that will be paid next year is $3, with an expected growth (g) of 4% annually. 

The intrinsic value is computed as follows:

P = $3/(8%-4%)= $75

The above calculation indicates that the present value of the stock equals $75, while the market value of the stock is $70. Furthermore, the stock is trading below the intrinsic value with a $5 difference. As a result, the stock is considered to be undervalued.

Dividend next year not given example

Suppose a company's stock price is $150, and the required rate of return is 6%. The growth rate is 4%, and the current dividend per share is 3$.

To calculate the dividend next year, we use this formula:

         D1 = D0 (1 + g) = ?

         D1 = $3 (1 + 4%) = 3.12

Now that we have the value of next year’s dividend (D1), we can proceed with the GGM:

P = $3.12/(6%-4%) = $156

In this example, the intrinsic value is higher than the market value. Therefore, the stock is considered undervalued.

Researched and authored by Elie Zakhour |  LinkedIn

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