The Gordon Growth Model is used to determine the value of a stock based on the current dividend per share and its expected constant growth rate. This model is a simplified version of the Dividend Discount Model. The Gordon Growth Model provides a relatively quick way of determining stock valuation with only knowledge of the dividend per share, an expected rate of return, and the expected dividend growth rate. There are some limitations to the model, but it works reasonably well for mature companies with fairly predictable and stable dividend growth rates. However, one should always compare the results of this model with other valuation methods.
The model takes a given dividend per share and solves for the present value of an infinite series of future dividends. One important aspect is that the model assumes a constant dividend growth rate out to infinite time. The formula for the Gordon Growth Model is
P = D / (r – g) (1)
where P is the present value of each share of the company, D is the annual dividend per share, r is the expected rate of return, and g is the expected annual dividend growth rate to infinite time. The quantity D is the easiest to determine as it is the actual dividend per share. The quantity g is an estimate but can be based on historical growth rates extrapolated into the future. The quantity r is also an estimate.
The result of equation (1) can be compared to the current share price. If the quantity P is greater than the current share price, then the stock can be considered overvalued and vice-versa. However, the Gordon Growth Model should not be used in isolation. Rather, it should be used in tandem with other valuation methods, e.g. price-to-earnings ratio.
The Gordon Growth Model has some limitations. The obvious one is that the model assumes a constant dividend growth rate. This is generally a valid assumption for mature companies that have been paying dividends for some time, e.g. Dividend Kings, Dividend Aristocrats, and Dividend Champions. However, it is generally not valid for companies that have only recently started to pay a dividend where the growth rate is very high initially and then tapers off. The assumption is also not valid for a company that has a volatile dividend growth rate due to cyclicality in the business cycle. For example, many industrial stocks exhibit long-term dividend growth but when the economy contracts and thus earnings contract the dividend growth rate is very small. On the other hand, when the economy and earnings are expanding the dividend growth rate tends to be relatively high.
The second important limitation is the subtractive relationship between the expected rate of return and the dividend growth rate. If these two quantities are the same then P approaches infinity, an obvious breakdown in the Gordon Growth Model. Additionally, if the quantity g is greater than the quantity r, then the result of equation (1) is a negative value and thus not meangingful.
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