What is the Gordon Growth Model & how to calculate it

Understanding how securities trade in the market is challenging. The explanation is that various factors influence share price fluctuation. These include regulations, corporate initiatives, and market attitude. The Gordon Growth Model is one of several methods for calculating the value of stocks. But what does this method entail? In this article, let’s get into everything you need to know about the Gordon Growth Model. 

Understanding the Gordon Growth Model

The Gordon Growth Model, also termed the Dividend Discount Model (DDM), is an approach used in finance to determine the intrinsic value of a company’s stock. The model assumes that a company’s dividends will continue to increase at a constant growth rate indefinitely. 

This model is handy for stable and mature companies with predictable dividend growth rates.

For those who are unaware, dividends are payments made by a company to its shareholders. They are usually derived from the company’s profits. The Gordon Growth Model considers the present value of these future dividend payments to calculate the value of the stock.

Wondering how it is different from the CAPM Capital Asset Pricing Model (CAPM)? In the CAPM vs Gordon Growth Model, CAPM is a financial model used to determine the expected return on an investment, considering the risk-free rate, the investment’s systematic risk, and the expected market return. It is particularly useful for pricing risky securities and calculating the cost of equity.

On the other hand, GGM focuses on valuing a stock based on its dividend growth.

Formula of Gordon Growth Model

Here is the Gordon Growth Model formula.

P = (D_1) ÷ (r – g)

Where:

• ( P ) is the current stock price
• ( D_1 ) is the expected dividend for next year.
• ( r ) is the required rate of return or discount rate
• ( g ) is the growth rate of dividends

Here is the step-by-step breakdown of the Gordon Growth Model derivation:

• If the current dividend is ( D_0 ), and you expect it to grow at a steady rate, you can calculate ( D_1 ) as ( D_0 \times (1 + g) ).
• Computing the required rate of return can be accomplished using the Capital Asset Pricing Model (CAPM) or by examining the average returns of similar stocks.
• The dividend rate is expected to grow indefinitely. It should be less than the required rate of return to make the model work.

Example of Gordon Growth Model

Suppose a company’s current dividend (( D_0 )) is Rs 100, and you expect the dividends to grow at a rate of 5% per year (( g = 0.05 )). If the required rate of return (( r )) is 10%, the expected dividend next year (( D_1 )) would be Rs 105 (( D_0 \times (1 + g) )).

Using the Gordon Growth Model formula:

P= (105) ÷ (0.10 – 0.05) 

= (105) ÷ (0.05)

= Rs 2100

Advantages and Downsides of the Gordon Growth Model

Here are the benefits and drawbacks of the model:

Benefits:

• Simplicity: The GGM is straightforward and easy to use, requiring only a few inputs to calculate a stock’s value.

• Focus on dividends: It is particularly useful for companies with stable and predictable dividend policies, as it directly relates the stock price to the dividends.

• Widely accepted: The model is widely recognized and used by analysts and investors, making it a standard tool for valuation.

• Long-term perspective: It encourages a long-term view of investment, focusing on future cash flows rather than short-term market fluctuations.

Drawbacks:

• Reliance on stable growth: The model assumes a perpetual growth rate that can be difficult to estimate and does not account for changes in growth over time.

• Dividend-centric: It is not applicable to companies that do not pay dividends or have an irregular dividend policy.

• Sensitive to inputs: The valuation is highly sensitive to the inputs used, particularly the growth rate and discount rate. Slight modifications in these assumptions can lead to significant differences in the calculated value.

• Ignore non-dividend factors: The GGM does not consider other factors that might affect a company’s value, such as brand loyalty, customer retention, or ownership of intangible assets.

Conclusion 

To sum up, while the Gordon Growth Model is a useful tool for valuing dividend-paying stocks, its effectiveness is limited by its assumptions and applicability. It works best for mature companies with a history of stable dividend payments and growth rates. Investors should be cautious of the model’s sensitivity to input changes and its limitations when applying it to companies with more complex or uncertain dividend policies. To learn more about investing, subscribe to StcoGro. 

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