Investors buy stocks to participate in the growth of a company. Many stocks reward investors with dividend payments, but how do you know whether you’re paying more for a stock than what it is worth? The Gordon growth model (GGM) is a simple method that helps estimate stock valuation based on dividends. By focusing on dividends and their growth, you can evaluate a company’s ability to generate future cash flow. Learn how the Gordon growth model works and when it is most effective.
Understanding the Basics of the Gordon Growth Model (GGM)
The Gordon growth model is a financial model that estimates a stock’s intrinsic value, which is a fundamental stock valuation based on the company’s performance. Unlike market value, which is the stock price investors are willing to pay, intrinsic value is meant to be an objective measure of a stock’s worth. The GGM specifically measures stock value based on the company’s dividend payments. It offers an easy way to compare the stock market price to its intrinsic value.
The GGM takes an infinite series of future dividend payments and discounts them back to their present value using the required return rate.
Gordon Growth Model Formula
The Gordon growth model calculates intrinsic value using the formula: V₀ = D₁ / (k - g).
Three key inputs necessary for this calculation include:
- D₁: Dividends per share (DPS) expected in the next period. DPS represents the future cash flow to shareholders. The DPS are often based on the company’s payout history.
- k: Required rate of return. The smallest return that an investor would consider when buying a company’s stock is the required rate of return. The required rate of return is also known as the discount rate.
- g: Growth rate in dividends per share. The DPS growth rate is the annual rate of increase in dividends. While the DPS growth rate is often estimated based on the company’s past dividend payouts, there is no guarantee of future dividend payments.
Key Assumptions of the Gordon Growth Model
The GGM relies on several key assumptions, including:
- Dividends paid per share grow at a constant rate
- Dividends are the only source of investor return
- The required rate of return remains consistent
- The company exists forever
The GGM is highly dependent on the accuracy of these assumptions. If a company reinvests its earnings rather than paying dividends or experiences changes in its risk profile, the GGM may not accurately represent the stock’s intrinsic value.
Importance of Dividend Growth Rate (g)
The dividend growth rate is a significant assumption in the model as it represents the expected annual growth rate and directly affects the stock’s intrinsic value. Higher dividend growth rates imply greater future cash flows, resulting in a higher intrinsic value. Conversely, lower dividend growth rates lower the stock’s value.
You can calculate the dividend growth rate by looking at historical trends in the company’s growth rate. The dividend growth rate is purely an estimate because past performance does not necessarily reflect future trends.
Determining the Required Rate of Return (k)
The required rate of return reflects the minimum return an investor expects to earn to justify investing. Risk is one of the significant factors influencing the required rate of return. You may seek a higher rate of return on a riskier investment.
The following factors can affect your required rate of return:
- Risk-free rate of return: The expected return for an investment with zero risk is the risk-free rate. The interest rate on a U.S. Treasury bill is typically the risk-free rate as there is minimal chance that the U.S. government will default on its obligations.
- Market risk premium: The difference between a stock’s expected return and the risk-free rate
- Stock-specific risk: Hazards that apply to a particular company or industry
A common way to calculate the required rate of return is to use a dividend discount model (DDM).
The Gordon growth model is a popular DDM used to calculate the required return on investment with the following formula:
k = (Expected dividend payment / share price) + dividend growth rate.
Practical Application and Limitations of the Gordon Growth Model
To illustrate how the GGM model works, assume Company A’s stock is trading at $90 per share. The DPS is $3 with an estimated yearly 3% growth rate. The required rate of return is 5%.
Based on the above factors, the GGM formula looks like this:
V₀ = $3 / (5% - 2%) or $100 per share
While the market price is $90 per share, the intrinsic value is higher at $100 per share. Based on the GGM, the stock appears undervalued in the market by $10 per share. Company A’s stock may be worth a second look.
Conversely, if Company A’s shares were trading at $110, the stock appears overvalued in the market by $10 per share when compared to its intrinsic value.
Although the Gordon growth model is one of the more popular dividend discount models, alternative stock valuation methods exist.
- The discounted cash flow model (DCF) calculates intrinsic value based on the present value of free cash flow in perpetuity.
- Net present value calculation can estimate the current value of an investment by calculating the current value of future cash flows.
The main limitation of GGM is that it assumes a constant increase in dividends per share. Operational changes, market conditions or unexpected financial difficulties can hinder a company’s growth and dividend payouts. The model is most effective for firms with stable dividend growth rates.
Another issue occurs with the relationship between the required rate of return and dividend growth rate. The GGM model renders a negative outcome when the required rate of return is less than the dividend growth rate. If the dividend growth rate and required rate of return are the same, the value per share approaches infinity.
Pros and Cons of the Gordon Growth Model
Using the Gordon growth model has benefits and drawbacks for investors.
Pros
- Simple formula to use and understand
- Can easily compare companies of diverse sizes and in different industries
- Ideal for mature companies that pay steady dividends
Cons
- Does not consider intangible factors that could affect earnings, such as brand recognition and customer loyalty
- Cannot be used to value stocks that don’t issue dividends
- May not be representative of a stock’s growth as it assumes a stable dividend rate
Gordon Growth Model Is a Simple Way to Value Dividend Growth
With the Gordon growth model, you can quickly calculate the intrinsic value of a company that pays steady dividends. The GGM provides a valuable tool to estimate stock values by making key assumptions. Despite its shortcomings, the GGM can help identify potential market opportunities.
Frequently Asked Questions
What is the Gordon growth model most appropriate for valuing?
The Gordon growth model is most appropriate for valuing the stock of mature companies with a history of paying dividends.
What is the two-stage Gordon growth model?
The two-stage Gordon growth model accounts for changes in the dividend growth rate. The two-stage model may assume one dividend growth rate for a period before transitioning to another dividend growth rate.
What is the basic assumption of the constant growth model?
The constant growth model assumes that a company experiences consistent dividend growth every year.
About Anna Yen
Anna Yen, CFA is an investment writer with over two decades of professional finance and writing experience in roles within JPMorgan and UBS derivatives, asset management, crypto, and Family Money Map. She specializes in writing about investment topics ranging from traditional asset classes and derivatives to alternatives like cryptocurrency and real estate. Her work has been published on sites like Quicken and the crypto exchange Bybit.