Gordon Growth Model (GGM)
What Is the Gordon Growth Model (GGM)?
The Gordon growth model (GGM) is utilized to decide the intrinsic value of a stock in light of a future series of dividends that develop at a consistent rate. It is a famous and clear variation of the dividend discount model (DDM). The GGM expects that dividends develop at a steady rate in perpetuity and tackles for the current value of the limitless series of future dividends.
Since the model expects a consistent growth rate, it is generally just utilized for companies with stable growth rates in dividends per share.
Understanding the Gordon Growth Model (GGM)
The Gordon growth model values a company's stock involving an assumption of consistent growth in payments a company makes to its common equity shareholders. The three key contributions to the model are dividends per share (DPS), the growth rate in dividends per share, and the required rate of return (RoR).
The GGM endeavors to compute the fair value of a stock independent of the overarching market conditions and thinks about the dividend payout factors and the market's expected returns. On the off chance that the value got from the model is higher than the current trading price of shares, then, at that point, the stock is viewed as undervalued and fits the bill for a buy, and vice versa.
Dividends per share address the annual payments a company makes to its common equity shareholders, while the growth rate in dividends per share is how much the rate of dividends per share increases over time one year to another. The required rate of return is the base rate of return investors will acknowledge while buying a company's stock, and there are different models investors use to estimate this rate.
The GGM expects a company exists everlastingly and pays dividends per share that increase at a steady rate. To estimate the value of a stock, the model takes the endless series of dividends per share and discounts them back into the current utilizing the required rate of return.
The formula depends on the mathematical properties of a limitless series of numbers developing at a consistent rate.
Source: Stern School of Business, New York University.
The principal limitation of the Gordon growth model lies in its assumption of steady growth in dividends per share. It is exceptionally rare for companies to show consistent growth in their dividends due to business cycles and unexpected financial hardships or victories. The model is consequently limited to firms showing stable growth rates.
The subsequent issue happens with the relationship between the discount factor and the growth rate utilized in the model. On the off chance that the required rate of return is not exactly the growth rate of dividends per share, the outcome is a negative value, delivering the model worthless. Likewise, in the event that the required rate of return is equivalent to the growth rate, the value per share approaches endlessness.
Illustration of the Gordon Growth Model
As a theoretical model, consider a company whose stock is trading at $110 per share. This company requires a 8% least rate of return (r) and will pay a $3 dividend for each share next year (D1), as would be considered normal to increase by 5% annually (g).
The intrinsic value (P) of the stock is calculated as follows:
As per the Gordon growth model, the shares are currently $10 overvalued in the market.
Features
- The GGM is great for companies with consistent growth rates given its assumption of steady dividend growth.
- The GGM works by taking a boundless series of dividends per share and discounting them back into the current utilizing the required rate of return.
- It is a variation of the dividend discount model (DDM).
- The Gordon growth model (GGM) expects that a company exists everlastingly and that there is a steady growth in dividends while esteeming a company's stock.
FAQ
What Are the Drawbacks of the Gordon Growth Model?
The GGM's principal limitation lies in its assumption of steady growth in dividends per share. It is exceptionally rare for companies to show steady growth in their dividends due to business cycles and unexpected financial troubles or victories. The model is hence limited to companies with stable growth rates in dividends per share. Another issue happens with the relationship between the discount factor and the growth rate utilized in the model. On the off chance that the required rate of return is not exactly the growth rate of dividends per share, the outcome is a negative value, delivering the model worthless. Likewise, in the event that the required rate of return is equivalent to the growth rate, the value per share approaches boundlessness.
What Are the Inputs for the Gordon Growth Model?
The three contributions to the 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 a company makes to its common equity shareholders, while the DPS growth rate is the yearly rate of increase in dividends. The required rate of return is the base rate of return at which investors will buy a company's stock.
What Does the Gordon Growth Model Tell You?
The Gordon growth model (GGM) endeavors to work out the fair value of a stock independent of the overall market conditions and thinks about the dividend payout factors and the market's expected returns. On the off chance that the GGM value is higher than the stock's current market price, the stock is viewed as undervalued and ought to be bought. Alternately, on the off chance that the value is lower than the stock's current market price, the stock is viewed as overvalued and ought to be sold.
