The volatility of the stock market has changed the way investors value their wealth. To win the investors' trust, managers have to assure them of a predictable return for their investments. One of the techniques of calculating returns is the constant dividend discount model, also known as the Gordon growth model. This is a model for determining the market value of a share, based on future dividends that grow at a constant rate. This model assumes that the dividend grows at a constant rate indefinitely, and it has many advantages over other methods.
Calculating the growth of shares is a complex and difficult task. Most investors lack this skill. This model is simple to apply, and investors can easily calculate the growth of his stock. This saves the investor the cost of hiring a specialist. He is able to make decisions on timely and accurate manner.
The stock market is very uncertain and risky. Investors are generally risk averse and require the best returns from their investments. Under the constant dividend discount model, investors receive a fixed return on investment. A firm using this model should be growing at a stable rate. The earnings of such a company are growing at the same rate as the dividend, hence investors are certain that the company will meet its obligations.
Investors do not solely purchase stocks to receive dividends. They can purchase stocks to influence the activities of a company or to control it. The constant dividend discount model presumes that investors purchase stock to receive dividends in the future. There is logic in this model, because investors usually are paid dividends on the shares they hold in a company.
Investors would like to know the future value of their investments. They do this by looking at the price of a share and using this model to calculate the dividend growth rates of a company. This is possible if the predicted value of a share is known and you want to calculate the expected dividends. This is a very useful technique of predicting one’s wealth in the future.
It is common with companies to share the increase in profits with shareholders. Under the constant dividend discount model, when a company makes more profits than anticipated, shareholders do not receive more dividends. The management can re-invest these funds and grow the company’s asset base. Shareholders will neither lose nor gain from any change in the company’s market value.
- McGraw-Hill Higher Education: Introduction to Investments
- “Fundamentals of Corporate Finance, 5th edition”; Richard A. Brealey; 2007
- New York University Leonard N. Stern School of Business: Chapter 13, Dividend Discount Models
- QFinance: Applying the Gordon Growth Model
- “Financial Management, 10th edition”; I. M. Pandey; 2010