Gordon Growth model is based on the concept of dividend growth in the future. If the company does not make some significant breakthrough/unexpected growth or faces some extreme misfortune, then the growth depends on doing more for the same work. For instance, if the company has four retail outlets, it needs to expand from 4 outlets to 5 by investing in growth and development.
This growth and development of the company are dependent on the retention of the profit if we ignore external financing. So, If the company distributes all of its earnings as a dividend, it does not have the capital to invest in projects for growth and development. It means the company’s growth depends on the rate of profit earned and subsequent retention, which can be shown as follows as the formula below:
g = bR
Where g is the company’s rate of growth, b is the percentage of earnings retained by the company, and R is the profitability earned by the company on new investment. As per the given equation, if there is an increase in the b or profit retention, the growth rate is expected to increase. It’s due to the logic that more retained earnings allow the company to invest more and earn more and pay more like a dividend.
Let’s understand in detail that how Gordon’s growth model calculates the value of the firm. So, this model uses an expected series of dividends by the company in the future and growth rate. The expected dividend is discounted in the present time by using the discounting technique.
Understanding Gordon Growth Model
Gordon’s growth model helps to calculate the value of the security by using future dividends. The formula for GGM is as follows,
- D1 = Value of next year’s dividend.
- r = Rate of return / Cost of equity.
- g = Constant rate of growth expected for dividends in perpetuity.
This model does not consider external factors that significantly impact the company’s capitalization but is centered around market expected returns and payout retention. Suppose the value calculated by GGM is higher than the current share price in the market. In that case, the security is considered to be undervalued compared to the dividend generating capacity, and a security purchase decision is recommended. On the other hand, if the value calculated by GGM is less than the current trading price in the market, the security is said to be over-valued, and purchase decision is not recommended.
The logic of the whole model is that if you retain stock of the company in perpetuity. Its value will be realized by receipt of the dividend in perpetuity. So, we do a discounting of the constantly growing dividend per share in perpetuity with a required rate of return. This gives us the potential of the security to generate dividends for the rest of its life. Hence, we can compare it with the current share price.
However, there are certain limitations of this model. It assumes dividend grows at a constant rate for the company’s whole life, which may not be true in reality as reality is much dynamic and there are ups and downs in the business. So, it’s a limitation of the model which limits its use just for stable companies.
Another problem with this model is the relationship between growth rate and discount factor. If some company has a required rate of return lower than the growth rate of dividend per share, the result is a negative value calculated by GGM.
In addition to this, if the growth rate of dividend and required rate of return is the same, the value calculated gives a mathematical error and can be considered in infinity. However, the main benefit of the GGM is to assess the under/overvaluation of stock by comparing the current trading price and internal growth potential of the business in the future.
Example of Calculation for the Gordon Growth Model
Suppose the current share price of the company’s share is $110 per share. The required rate of return by the shareholders of the company is 8%. The company intends to pay a $3 dividend per share, and the expected growth rate is 5%. The current trading price of the share is $110.
The value of the share in the Gordon Growth Model can be calculated as follows.
- D1 = Dividend in the next year = $3
- R = required rate of return = 8%
- g = Growth rate of a dividend = 5%
The value calculated with the GGM amounts to $100, and the current trading price of the shares is $110. It means there is less potential for the shares to generate dividends than the current share price. So, security is overvalued, and purchase decision is not recommended.
Assumptions of the Model
- Growth of the dividend is constant for whole life of the business.
- No external factors impact the share price and earnings of the company.
- The rate of growth is lower than the expected rate of return.
- The company pays all of its free cash flow in the form of a dividend.
- The business model of the company is stable alongwith constant rate of growth. Further, No significant changes are expected in the operating structure of the business.
- The financial leverage of the company is stable.
- The business does not avail of external financing for the rest of its life. Instead, the earnings of the business are reinvested after the payment of the dividend.
- The rate of return remains the same for the whole life of the business.
- The retention ratio of the dividend is constant.
When Should Gordon Growth Model be Used?
The Gordon Growth model seems to produce be useful in the following circumstances.
- The business has established internal operations.
- The company believes in regular payment of the dividend.
- The company’s dividend is expected to grow at a constant rate.
- The growth rate of the company is expected to be lower than the required rate of return.
- The company does not retain free cash flow while pays all of its free cash flow in the form of a dividend.
Frequently asked questions
Why is the Gordon Growth model used?
This model calculates the fair value of the stock. It does not consider external environmental conditions that impact the business but dividend payout factors, expected rate of return, and the growth of the dividend. If the value calculated by GGM is more than the company’s current trading price, the security is said to be under-valued, and purchase is recommended and vice versa.
What are the inputs required for the Gordon Growth Model?
There are three inputs in the Gordon Growth model. These models include Dividend per share (DPS), rate of growth for the dividend in the perpetuity, and the required rate of return. Dividend per share is the dividend announced by the company against each share. The rate of growth is the expected growth rate for dividends in the future, and the required rate of return is the return desired by investors on their investments.
What are the limitations of the Gordon Growth Model?
First of all, It does not consider the external environmental conditions of the business and depends on limited input factors. Secondly, it assumes growth of the dividend is constant in perpetuity which may not always be true. Thirdly, if the rate of growth and required rate of return is the same, the calculations will lead to an infinite value.
Finally, this model can only be applied to the companies that pay a dividend. There may be companies that do not pay dividends instead reinvest the whole amount. In such cases, the Gordon Growth model seems to be of no use.
Why Gordon Growth model uses dividend instead of cash flow?
In the Gordon Growth Model, we actually use cash flow while it seems to be a dividend. It’s because these models assume the company pays all of its equity-free cash in the form of a dividend.