valuation

Understanding the Gordon Growth Model for Stock Valuation

Introduction

The Gordon Growth Model (GGM) provides a straightforward method for stock valuation, predicated on the future dividend payments of a company. This model operates under the assumption that a company's dividends will increase at a constant growth rate indefinitely.

Formula for the Gordon Growth Model

The formula for calculating the intrinsic value of a stock using the GGM is as follows:

[ P = \frac{D_1}{(r - g)} ]

Where:

  • P = Intrinsic value of the stock
  • D₁ = Expected dividend for the next year, calculated as (D₀ \times (1 + g))
  • r = Required rate of return (cost of equity)
  • g = Constant dividend growth rate

How to Use the GGM

To determine the fair price of a stock using the GGM, gather the following information:

  1. The company’s expected dividend (D₁)
  2. The anticipated growth rate of dividends (g)
  3. The investor’s required return (r)

Example Calculation

Consider a company that pays a current dividend (D₀) of ₹5 per share, anticipates a growth rate of 4% per year, and requires a return of 10%. The calculation using GGM would be:

[ P = \frac{5(1.04)}{(0.10 - 0.04)} ]

Calculating this gives:

[ P = \frac{5.2}{0.06} = ₹86.67 ]

Thus, the fair value of the stock is approximately ₹86.67 per share.

When is the GGM Useful?

The GGM is particularly beneficial for:

  • Valuing shares of companies that consistently pay and grow dividends, such as blue-chip stocks.
  • Cases where dividends represent the primary source of returns for investors.

Limitations of the GGM

While the GGM is useful, it does have certain limitations:

  • It is not applicable if (g \geq r) since growth cannot exceed the required rate of return.
  • It is ineffective for companies that do not pay dividends.
  • The assumption of constant dividend growth may not reflect real-world conditions.

Alternatives to the GGM

Consider these alternatives for stock valuation:

  • Discounted Cash Flow (DCF): Focuses on cash flows rather than dividends.
  • Dividend Discount Model (DDM): A broader formulation of the GGM.
  • Price/Earnings (P/E) Ratio: Evaluates based on earnings instead of dividends.

Conclusion

The Gordon Growth Model serves as a practical tool for assessing stock value through future dividend projections. It aids investors in estimating fair stock prices, under the premise of stable dividend growth. Despite its efficacy for companies with regular dividend increases, the GGM has limitations when addressing high-growth or dividend-absent firms. For a thorough investment analysis, it is advisable to leverage the GGM in conjunction with other valuation methodologies, such as the Discounted Cash Flow (DCF) model or Price/Earnings (P/E) ratio assessments.