What is the Gordon Growth Model?
You don't have to be a big-time businessman, entrepreneur, or investor to be eager to invest in a stock. The buying of shares isn't a business for only the rich, but everyone. It can also turn your fortunes around if you know a thing or two about the market, and invest in the right company.
However, before you invest in a stock, it's essential to conduct your research. Ensure you are aware of the valuation of the company of interest. That's where the Gordon Growth Model (GGM) comes in handy. This software can help you determine what the value of the proposed company's stock would be in time to come.
Continue reading for more information about this model.
Understanding the Gordon Growth Model
You may be hearing about this model for the first time or have heard but didn't pay much attention or consider how relevant it is. By and large, it's a cool model that can help with valuable information that can enable individuals to make an educated decision concerning where to invest their money. The model has its advantage, disadvantages, or limitations, as you may call it. Nevertheless, it's worth taking a look at.
So what does the Gordon Growth Model imply? It's a model that can help to figure out a stock's intrinsic value based on factors such as the future series of dividends, which has been growing at a consistent rate.
It's also important to note that the Gordon Growth Model (GGM for short) only assumes that the growth rate is constant. And as a consequence, one can only use it for firms whose dividends per share has a stable growth rate.
The Gordon Growth Model Formula
This model has a formula, and so it relies on figures to produce a prediction for a certain period. The prediction one can give with regards to this formula must be based on the outcome of the calculation.
Below is the GGM's formula, including what each term stands for.
P = D1/r-gP = the letter P indicates the current stock price of the company of interest.
D1 = Next year's dividend's value
r = the company's consistent cost of equity capital
g = Constant growth rate, which is expected for dividends, in perpetuity.
Gordon Growth Model Formula Assumptions
Before applying the Gordon Model, there are certain assumptions you need to consider. Otherwise, the model may not produce the expected outcome.
Below are some of those assumptions;- It is assumed that the company's life is indefinite.
- We also have to assume that the growth of the firm is at a constant rate.
- The firm's financial leverage is stable, or it doesn't have any financial leverage attached to it.
- The required rate of return is higher and better than the growth rate.
- The required rate of return of the firm remains constant.
- The company's free cash flow is paid out as dividends at consistent growth rates.
The Vital Information that the Gordon Growth Model Seeks to Provide
There is critical information that the Gordon model seeks to offer. Hence, the model has enjoyed widespread acceptance for predicting companies with a stable financial growth rate. The Gordon Growth Model helps to value the stock of a firm, and it does so via an assumption of a consistent rise in payments. This payment involves the money the company pays to its equity shareholders.
Key inputs of the GGM. This growth takes into account three critical inputs, which are growth rate in dividends per share, dividends per share, and the required rate of return. They are the three components that make up the GGM formula mentioned above.
Let's look at each of the three key inputs in details:
Dividends per share (D) - This input talks about the yearly payments, which a firm offers to its common equity shareholders. It is represented with the letter "D," as seen in the formula above.
The growth rate in dividends per share (g) - Here is another parameter you will find on the formula given above. It is called the growth rate and looks at the level at which the rate of dividends per share rises, year to year. It is represented with the letter "g" in the Gordon Growth Model formula.
The required rate of return (r) - Thisinput concerns the minimum rate of return, which investors are ready to accept when purchasing the stock of the company. Furthermore, there are diverse models an investor can use to estimate it.
What the Gordon Growth Model assumes is this. Remember that we said that the model only works for firms whose dividends grow at a constant rate. So the model assumes that a firm exists indefinitely and pays dividends for each share, which rises at a steady rate.
Despite the condition of the market, this model still calculates a stock's fair value and takes into account different factors. These include the market expected returns and dividend payout factors.
Now here's the trick. If, after calculation, you end up with a value that's way higher than the current shares trading price, then the stock is said to be undervalued. In such a case, it is said to quality for purchase, and vice versa.
Advantages and Disadvantages of the Gordon Growth Model
Let's consider the advantages and disadvantages the GGM has. What makes it superior, or what are its limitations? Read on!
Advantages of the Gordon Growth Model
1. SimplicityThis valuation model is super easy to understand and apply. The reason for this is that its inputs are available, and you can even assume them by accessing the firm's financial statements or annual report.
2. EfficientYou will find the model more efficient for more stable firms, particularly those that have limited business expenses and good cash flow.
3. ScopeThe model has widespread application in the real estate sector, and its proving to be a handy tool for investors and agents alike.
Disadvantages of the Gordon Growth Model
1. Precision RequiredOne of the drawbacks or limitations the model has is the assumption of steady growth in the dividend. Even the best companies in the world might have challenges to maintain a constant growth rate due to factors like changes in the market, financial difficulties, among others.
2. Not Useful for all CompaniesThe model is not useful for companies with financial leverage or those with unstable cash flows.
3. Negative Value ResultThe model can result in a negative value if the required rate of return is very less than the growth rate.
