Analysts and investors use dividend growth models to calculate the intrinsic value of a company's stock and make decisions on whether to buy or sell. The Gordon Growth Model is a simple model that uses the dividend growth rate of a company to determine an intrinsic value. It is very popular because it uses information that is easy to find and apply.
What Is a Growth Model?
Investors buy stocks with the expectations that their prices will rise because of the company's increased earnings and higher outflows of dividends to the shareholders. Growth models attempt to take the future flow of dividends and equate them to a present intrinsic value of the stock, which can be used to make investment decisions.
Definition of the Gordon Growth Model
Investors use the Gordon Growth Model to determine the intrinsic value of a stock based on receiving a continuous stream of future dividends that are assumed to grow at a constant rate. The intrinsic stock price is calculated on the discounted present value of the future series of dividends.
The Gordon Growth Model only needs three types of data for its calculation:
- Current dividend payout.
- Projected dividend growth rate.
- The rate of return required by the shareholders.
The formula is as follows:
Intrinsic value of the stock = Current dividend/(rate of return - dividend growth rate)
The Gordon Growth Model calculates the value of a stock regardless of changes in market conditions. This is important because it allows investors to compare the valuation of companies in different industries.
The Gordon Growth Model makes the following assumptions:
- The company has a stable business model and does not make any substantial changes in its operations.
- The financial leverage of the company remains constant.
- The business has a constant growth rate.
- Dividends are expected to grow at a constant rate.
- All the company's free cash flow is distributed as dividends to equity shareholders.
Assume the stock of Blue Widget Corporation is trading at $35 per share. The investors require a 12 percent rate of return, the dividend growth rate is projected to remain steady at 4 percent and the company is currently paying a dividend of $2 per share.
The intrinsic value of the stock would be:
Intrinsic value = $2/(0.12 - 0.04) = $25
In this case, the stock of Blue Widget Corporation is overvalued. The model says that the value of the stock is $25 but it is currently trading at $35 per share.
The primary weakness of the Gordon Growth Model is the assumption that dividends will continue to grow at a constant rate in perpetuity. A company is rarely able to grow its dividends at a constant rate because of fluctuations in business cycles and unanticipated financial problems or increased opportunities for investments. Companies may decide to conserve cash in economic downturns or use their cash to make opportunistic acquisitions. In either case, the dividend flow would be affected.
The Gordon Growth Model works best to value the stock price of mature companies with low to moderate growth rates. It does not lend itself to accurate valuations for high-growth companies in the early stages of development.
If a company does not pay a dividend, earnings per share can be substituted. However, the earnings per share growth rate will most likely be different than a dividend growth rate in the future if the company decided to start paying a dividend.
Because of its simplicity, the Gordon Growth Model is widely used. The data needed for the calculations is readily available or simple to estimate. However, the Gordon Model does not take into consideration such non-financial factors such as patents, brand strength or diversification that influence the value of a company's stock.