Gordon growth model (GGM) definition and formula


What is Gordon’s Growth Model (GGM)?

The Gordon Growth Model (GGM) is used to determine the intrinsic value of a stock based on a future series of dividends that grow at a constant rate. It is a popular and simple variant of the Dividend Discount Model (DDM). The GGM assumes that dividends grow at a constant rate in perpetuity and calculates the present value of the infinite series of future dividends.

Because the model assumes a constant growth rate, it is generally only used for companies with stable growth rates in dividends per share.

Key takeaways

  • Gordon Growth Model (GGM) assumes that a company exists forever and that there is constant growth in dividends when valuing a company’s stock.
  • GGM takes the infinite series of dividends per share and discounts them to the present using the required rate of return.
  • GGM is a variant of the dividend discount model (DDM).
  • GGM is ideal for companies with constant growth rates given its assumption of constant dividend growth.

Understanding Gordon’s Growth Model

Gordon’s growth model values ​​the shares of a company by assuming steady growth in the payments a company makes to its shareholders in common capital. The three key inputs in the model are dividends per share (DPS), the growth rate in dividends per share, and the required rate of return (RoR).

The GGM attempts to calculate the fair value of a share regardless of prevailing market conditions and takes into consideration dividend payment factors and expected market returns. If the value obtained from the model is higher than the current trading price of the stock, then the stock is considered undervalued and qualifies for a purchase, and vice versa.

Dividends per share represent the annual payments that a company makes to its common capital stockholders, while the growth rate of dividends per share is how much the dividend per share rate increases from year to year. The required rate of return is a minimum rate of return that investors are willing to accept when buying shares in a company, and there are several models that investors use to estimate this rate.

GGM assumes that a company exists forever and pays dividends per share that increase at a constant rate. To estimate the value of a share, the model takes the infinite series of dividends per share and discounts them to the present using the required rate of return.

The formula is based on the mathematical properties of an infinite series of numbers that grow at a constant rate.

P

=

D

1

r


gram

where:

P

=

Current share price

gram

=

A constant growth rate is expected for

dividends, in perpetuity

r

=

Constant cost of capital stock for the

company (or rate of return)

D

1

=

Value of next year’s dividends

begin {align} & P = frac {D_1} {r – g} \ & textbf {where:} \ & P = text {Current share price} \ & g = text {Se expect a constant growth rate for} \ & text {dividends, in perpetuity} \ & r = text {Constant cost of equity for the company} \ & text {(or rate of return)} & D_1 = text {Value of the next dividend of the year} \ end {aligned}

P=rgramD1where:P=Current share pricegram=A constant growth rate is expected fordividends, in perpetuityr=Constant cost of capital stock for thecompany (or rate of return)D1=Value of next year’s dividends

Source: Stern School of Business, New York University

The main limitation of Gordon’s growth model lies in its assumption of constant growth in dividends per share. It is very rare for companies to show constant growth in their dividends due to economic cycles and unexpected financial difficulties or successes. Therefore, the model is limited to companies that show stable growth rates.

The second problem occurs with the relationship between the discount factor and the growth rate used in the model. If the required rate of return is less than the growth rate of dividends per share, the result is a negative value, rendering the model worthless. Also, if the required rate of return is the same as the growth rate, the value per share approaches infinity.

Gordon’s growth model example

As a hypothetical example, consider a company whose stock is trading at $ 110 per share. This company requires a minimum rate of return of 8% (r) and will pay a dividend of $ 3 per share next year (D1), which is expected to increase by 5% per year (g).

The intrinsic value (P) of the share is calculated as follows:

P

=

$

3

.

08


.

05

=

$

100

begin {aligned} & text {P} = frac { $ 3} {.08 – .05} = $ 100 \ end {aligned}

P=.8.5$3=$1

According to Gordon’s growth model, stocks are currently overvalued in the market by $ 10.

What does Gordon’s growth model tell you?

Gordon Growth Model (GGM) attempts to calculate the fair value of a share regardless of prevailing market conditions and takes into consideration dividend payment factors and expected market returns. If the value of GGM is higher than the current market price of the stock, then the stock is considered undervalued and must be bought. Conversely, if the value is less than the current market price of the stock, the stock is considered to be overvalued and must be sold.

What are the inputs to Gordon’s growth model?

The three key inputs in GGM are dividends per share (DPS), the growth rate in dividends per share, and the required rate of return (RoR). DPS is the annual payments that a company makes to its ordinary capital stockholders, while the DPS growth rate is the annual rate of increase in dividends. The required rate of return is the minimum rate of return that investors are willing to accept when purchasing shares in a company.

What are the disadvantages of Gordon’s growth model?

GGM’s main limitation lies in its assumption of constant growth in dividends per share. It is very rare for companies to show constant growth in their dividends due to economic cycles and unexpected financial difficulties or successes. Therefore, the model is limited to companies with stable growth rates in dividends per share. Another problem occurs with the relationship between the discount factor and the growth rate used in the model. If the required rate of return is less than the growth rate of dividends per share, the result is a negative value, rendering the model worthless. Also, if the required rate of return is the same as the growth rate, the value per share approaches infinity.

www.investopedia.com

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