Gordon Growth Model

The Gordon Growth Model (GGM) is a stock valuation method that is used to determine the intrinsic value of a stock, considering the sum of the present value of the future dividend payments. 

GGM ignores the state of the market at the present time and focuses on determining the intrinsic value of the stock, assuming a constant rate of growth for future dividends. It is also considered a form relating to the Dividend Discount Model (DDM).

Sometimes investors wonder when buying a share of stock if they are overpaying. Therefore, it is likely that they perform a valuation method such as the Gordon Growth Model to determine the well-being of their investment.

This method was published by Professor Myron J. Gordon, to value stocks or businesses. 

Principally, it assumes an infinite series of future dividends with a constant growth rate in perpetuity that lasts forever, and it is mostly used for businesses with fixed dividend growth rates. 

Gordon Growth Model Explained

The Gordon Growth Model values the present value of the stock price based on an infinite stream of future dividends. 

The variables used to calculate the GGM are the dividend per share (DPS), the required rate of return (r), and the dividend growth rate per share (g).

Usually, this model is easy to use because it only includes three variables, and they are found in a company's financial reports.

For the most part, this model attempts to value a stock based on the expected market returns and dividend payouts. Also, it will certainly help investors to make decisions when comparing stocks. 

In this regard, after conducting this method, if the value obtained is lower than the market price of the share, the stock is considered overvalued.

Whereas, if the obtained value is higher than the current market price of the share, 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 dividends payouts are not recommended to use this model and should avoid it.

This method does not consider the market value of the company and the current economic condition. It only considers the growth of dividend payments. Therefore, the model can be used for companies of different sizes.

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 can be used when a company has unstable growth in the first stage and stable growth in the second stage. 

The formula is similar to the Gordon growth model, it only includes the growth rate (g) for the second stage. 

• The three-stage model includes a part of higher growth followed by positive or negative growth, then the growth rate stabilizes for the lifetime of the company.

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

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 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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