0 ITEMS
The Gordon Growth Model for Valuing Stocks
Companies’ economic value is estimated through the analysis of the company’s future earnings prospects, its capital structure, or market value of assets. The selection of an appropriate business valuation method depends on the available information, the goals, and the desired explanatory power of the valuation analysis.
One commonly used quick valuation method for estimating the value of stocks is the Gordon Growth valuation method – an income-based valuation method. It estimates the present value by discounting an expected income stream to its current value and considering the expected annual growth rate of such an income stream.
The Dividend Discount Model estimates a stock’s intrinsic value based on the forecasted dividend payments derived from the calculated value per share. If such dividends are expected to be constant and will benefit from a predictable annual growth rate in the future, the easiest way to estimate the value of the Dividend Income Stream is by using the Gordon Growth Valuation Method.
The Gordon Growth Valuation method can also be used when estimating Terminal Value in a Discounted Cash Flow (DCF) Valuation.
However, for this article, we will focus our analysis on understanding how to estimate the value per share of a publicly quoted company using the Gordon Growth Model.
What is the Gordon Growth Model?
Created by Professor Myron J. Gordon of the University of Toronto during the late 1950s, the single-stage Gordon Growth Model is the most frequently used method for valuing stocks of publicly quoted companies under the Dividend Discount Model.
The fundamental concept of the Gordon Growth method calculates a company’s fair Value per share, assuming that the dividends continue to grow indefinitely at a constant rate, independent of market conditions.
The Value per share (P) is calculated by dividing the expected dividends per share (D1) next year by the difference between the rate of return (r) and dividend growth rate (g). Therefore, the Gordon Growth formula is as shown on the right:
The 3 Assumptions of Gordon Growth
The Gordon Growth Model applied to dividends and share prices simplify the valuation process significantly. In estimating the value per share, there are only three variables needed:
1) Dividends Per Share (D)
It is the expected value of dividends issued to each shareholder for owning shares of the company. vs per share also represents the return on investment – how much return on equity shareholders should expect to receive per share.
2) Dividend Growth Rate (g)
The projected annual rate at which a stock’s dividend grows over time. If dividends are increasing at a higher rate, it could indicate a substantial likelihood of long-term profitability. The growth rate must be more than the required rate of return otherwise, the model will result in a negative value.
3) Rate of Return (r)
The rate of returns refers to the opportunity cost of capital an investor should be able to get on the stock market for investing in a stock with similar risk.
How to Value Stocks using Gordon Growth Model
The Gordon Growth Model aims to calculate the fair value of a stock based on dividend growth and the rate of return that a stockholder will get over time. This valuation excludes external factors such as the current market conditions.
To illustrate and understand the Gordon Growth Model, calculations are demonstrated below:
Dividend assumption provided is for the current year. To calculate the dividend for the next year, simply add the growth to the current year’s dividend:
With the completed components, the value per share is calculated as follows:
To summarize, below are the parameters in the calculation of Value per Share based on the Gordon Growth Model:
If the value calculated is higher than the current trading price, the stock is undervalued and may qualify as a signal to buy and result in a potentially profitable investment. On the other hand, if it is lower, the stock is overvalued and should be sold as it may not be a sound investment.
The video below explains how the Gordon Growth Valuation Method works and how it can be used in Excel.
Advantages and Disadvantages of Gordon Growth Model
Enumerated below are the advantages and disadvantages of using the Gordon Growth Model in estimating the value per share of a company.
Advantages
- Simple and easy-to-understand, making it convenient and handy for investors to use in comparing companies of different sizes, industries, and market capitalization.
- Inputs of the model are easily obtained from the financial reports of the company.
- Requires less assumptions: Dividend per share, dividend growth rate, and rate of return.
Disadvantages
- The GGM only works if a company has a constant income stream. It will not work if the income fluctuates too much.
- Dividends will continue to grow at the same rate indefinitely, which is unrealistic. It is impossible for any company to grow like that due to changes in market conditions and business cycles.
- Eliminates external factors such as prevailing market conditions or other factors like the size of the business, the market perception, consumer behavior, or the brand, resulting in stocks being undervalued despite a company’s brand and steady growth.
- The model is not suited for companies that have no dividend history.
To summarize:
When to Use the Gordon Growth Model
The Gordon Growth Model is one of the simplest valuation methods available, which quickly determines the value of a stock. With inputs readily available, this method offers a convenient, straightforward, and easy-to-understand way for investors to compare companies’ business values.
The main assumption of the Gordon Growth Model is that a company exists forever, and dividends will continue to grow indefinitely. Because the model assumes a constant growth rate, it is best suited for matured and developed companies with a steady pattern of dividend or growth.
However, assuming continuously growing dividends restricts its accuracy. It ignores non-dividend external factors, which may add to a business’s overall worth. Moreover, the model may produce a negative value if the required rate of return is lower than the growth rate; consequently, the model is not efficient or meaningful to use in such instances.
In this case, preference must be given to alternative valuation methods. So, while the Gordon growth model formula has its merits, the key is to know when to use the Gordon Growth Model and when not.
If you’re looking for financial model templates that include a DCF Valuation, please feel free to check out our full list of DCF Model templates here:
