Published On:Wednesday, 11 January 2012
Posted by Muhammad Atif Saeed
Gordon Growth Model
A model for determining the intrinsic value of a stock, based on a future series of dividends that grow at a constant rate. Given a dividend per share that is payable in one year, and the assumption that the dividend grows at a constant rate in perpetuity, the model solves for the present value of the infinite series of future dividends.
Where:
D = Expected dividend per share one year from now
k = Required rate of return for equity investor
G = Growth rate in dividends (in perpetuity)
explains 'Gordon Growth Model'
The Gordon growth model is a type of dividend discount model used to value companies expected to grow at a constant rate forever. Most valuation models forecast growth for a certain time period before reverting to a Gordon growth model to estimate the ending value.
Because the model simplistically assumes a constant growth rate, it is generally only used for mature companies (or broad market indices) with low to moderate growth rates.
Strengths:
- Especially useful for valuing stable-growth dividend paying companies
- Useful for valuing broad-based equity indices
- Simplicity and clarity
- Helpful in understanding relationships between value, growth, required return and payout ratio
- Useful for estimating expected rate of return
- Output highly sensitive to assumptions for growth rate and required return
- Not practical for valuing non-dividend paying companies
- Not practical for valuing dividend paying stocks with unstable growth characteristics
