What Is the Gordon Growth Model (GGM)?
The Gordon Growth Model is a stock valuation method that measures a stock’s present value by computing the future series of dividends assumed to be growing at a constant rate. The model is used to calculate a stock’s intrinsic value based on a future sequence of dividends. It is a well-known and straightforward variation of the dividend discount model (DDM). The GGM establishes a present value for an endless series of expected future payouts. It assumes that dividends will continue to rise at a constant rate in perpetuity. The model implies a continuous, steady growth rate. Therefore, it is best utilized for stable, mature corporations with consistent dividend growth rates per share.
The Gordon Growth Model is a prominent valuation tool. It is also one of the most widely utilized dividend discount models (DDMs). It is predicated on the assumption that a business’s dividend will rise at a constant rate in perpetuity. Therefore, it provides investors with a present value of the company based on that future sequence of payments. The approach works best with companies that have consistent dividend growth rates. For example, high dividend-yielding stocks on the Dow Jones Industrial Average.
Gordon Growth Model (GGM) – A Closer Look
The Gordon growth model values a company’s stock by assuming a constant increase in payments made to common shareholders. The model uses three major inputs. They are dividends per share (DPS), dividend growth rate, and required rate of return (RoR). The GGM seeks to compute the fair value of a company regardless of market conditions. Instead, it takes into account dividend payout considerations and the market’s predicted returns. If the model’s value is more than the current trading price of the stock, the stock is deemed cheap. As a result, it should be considered for purchase as a potential bargain. Conversely, if the model’s value is less than the current trading price, the stock is deemed expensive or overvalued.
Dividends per share are the annual payments made by a firm to its common equity shareholders. Whereas, the dividend growth rate is the percentage rise in dividends per share from one year to the next. The required rate of return is the minimal rate of return that investors are willing to accept when purchasing a company’s shares. This rate is estimated using a variety of available models and tools. The GGM implies a corporation exists in perpetuity and pays dividends that grow over time at a consistent rate. The model uses the required rate of return to discount the infinite sequence of dividends per share. In this way, it establishes the present value of a company based on its future stream of dividends and earnings. The formula is based on the mathematical principles of an endless series of numbers increasing at a constant rate.
Gordon Growth Model Formula
The Gordon Growth Model (GGM) estimates a company’s share price by assuming steady dividend growth. As previously stated, the method requires three variables. They are dividends per share (DPS), dividend growth rate (g), and the required rate of return (r).
Stock Price = D1 / (r – g)
- SP=Current stock price
- D1=Value of next year’s dividends
- r= Cost of equity capital for the company, or required rate of return
- g=Constant growth rate expected for dividends in perpetuity
Inputs for the Gordon Growth Model
The GGM has three inputs. These are dividends per share (DPS), dividend growth rate, and required rate of return (RoR). DPS refers to the annual payments made by a firm to its common equity shareholders. DPS growth rate refers to the annual rate of increase in dividend payouts. The required rate of return is the minimum rate of return that investors will accept when purchasing a company’s stock.
Gordon Growth Model Limitations
The Gordon growth model’s fundamental drawback is its assumption of continual dividend increase per share. It is extremely rare for corporations to achieve consistent dividend growth over the long term. This is due to a number of factors including business cycles, unanticipated financial troubles, or successes. As a result, the model is limited to mature enterprises with stable and consistent growth rates.
The second issue concerns the model’s link between the discount factor and the growth rate. If the required rate of return is less than the dividend growth rate, the model produces a negative number. In this instance, it renders the result practically useless. Furthermore, if the required rate of return equals the rate of growth, the value per share approaches infinity.
Example Using the Gordon Growth Model
As an example, consider a company whose stock is trading at $210 per share. This company requires a 7% minimum rate of return (r) and will pay a $5 dividend per share next year (D1). The dividend payout has a twenty-year history and consistently increases 5% annually (g).
The intrinsic value (SP) of the stock is calculated as follows:
SP = $5/ (.07 – .05) = $5 / .02 = $250
According to the Gordon growth model, the fair market value for the stock is $250 per share. The market price of the stock is only $210. Therefore, the shares are currently undervalued by $40 in the market ($250 – $210 = $40).
The Gordon Growth Model – Why It Matters
The Gordon growth model (GGM) aims to calculate the fair value of a company regardless of market conditions. It does this by taking into account dividend payout components and the market’s predicted returns. If the GGM value is more than the current market price, the stock is deemed undervalued. As a result, it should be given a closer look. It may even be considered for purchase. However, if the value is less than the stock’s current market price, the stock is considered overpriced. In that case, it should be passed over or possibly sold if it is in your portfolio.
The Gordon Growth Model is useful for determining the link between growth rates, discount rates, and valuation. The valuation is sensitive to changes in the discount rate. Yet, the model still shows a clear relationship between value and return. However, the model relies on a dividend issuance growth rate assumption. This makes it best suited for corporations with consistent dividend growth and no intentions for dividend revisions. In other words, the GGM is most commonly employed for mature companies in established markets. Solid companies that are insulated from circumstances that could result in a reduction or termination of their dividend payouts.
The Gordon Growth Model – Pros & Cons
There are several benefits to using the Gordon Growth Model, they include:
- Stock valuation basis – GGM assists investors in determining a definite starting point when valuing a company’s stock. It offers a foundation for determining whether or not the company is selling at a reasonable valuation. This is based on predicted future dividend payments, not fluctuating market conditions.
- Simplicity – It’s easy to use. The Gordon Growth Model enables investors to quickly value a company that pays a steadily growing dividend.
- Works well for mature, stable companies – It is appropriate for mature corporations with continuously increasing dividend payouts.
- Adaptable – It can be used as an input for more complex dividend-based stock valuation models. For example, two- and three-stage dividend payout models.
- Requires a consistent dividend growth rate – The GGM’s fundamental weakness is its assumption of a steady and perpetual dividend increase per share. It is extremely rare for corporations to achieve consistent dividend growth. This can be due to many factors including business cycles and unanticipated financial troubles or successes. As a result, the model is limited to corporations with consistent dividend growth rates per share.
- Discount factor vs growth rate – Another issue arises from the model’s link between the discount factor and the growth rate. If the required rate of return is less than the dividend growth rate per share, the model produces a negative number, rendering it useless. Furthermore, if the required rate of return equals the rate of growth, the value per share approaches infinity.
- Dividend manipulation – A concern for reliance on the GGM is that underperforming companies can issue large dividends to themselves. Or, management may be reluctant to cut dividends despite a deterioration in their financials. Hence, a disconnect between the fundamentals of the company and the dividend policy can occur. In those instances, the GGM would not capture the discrepancy.
Up Next: What Is Invested Capital?
Invested capital is the total investment by shareholders and bondholders when a company raises money by selling stock shares or issuing bonds. Debt, capital leases, and stockholder’s equity are all shown separately on the balance sheet. Therefore, invested capital is not a line item in the company’s financial statement.
The monies invested in a business during its life by shareholders, bondholders, and lenders are called invested capital. Non-cash assets can be supplied by shareholders. For example, the value of a building that is donated in exchange for shares. Or, the value of services rendered in exchange for shares. A corporation must make a return on its invested capital that exceeds the cost of that capital. Otherwise, the organization is steadily destroying the capital that was invested in it. As a result, invested capital is regarded as a financial analysis concept rather than an accounting notion.