Gordon growth model is a well-known model for the calculation of the intrinsic price of the shares. This model is widely accepted worldwide because it considers the realization of the return in the form of a dividend. Further, this model is dependent on the dividend policy.
Although, there are certain assumptions of the model, and one of them is the constant growth of the dividend. This is the reason that this model is used for companies that have stable business processes. Further, it’s easy to compare the calculated intrinsic value with the value calculated by the model. If the value calculated by GGM is more and the current market price of the security is low, we conclude that security is under-valued and recommend purchase. On the other hand, if the value calculated by GGM is less and the security’s current market value is high, we conclude that the stock is overvalued and does not recommend a purchase.
Another assumption of this model is that the business remains functional in perpetuity. In other words, the business keeps making payments for the dividend. Although this assumption might be somewhat unrealistic, still it provides an enhanced valuation of the earning capacity.
Two stages of dividend growth model
There are two-stage of the dividend growth model that includes,
1- ) Predicting the rate of dividend growth.
2- ) Discounting of the forecasted dividend growth.
Let’s discuss these stages of the dividend growth model in detail.
Predicting the rate of a dividend growth
This is the first stage of applying the dividend growth model. In this stage, the management predicts the rate of dividend growth. The management needs to exercise due judgment in predicting the rate of a dividend because it’s a subjective matter and one of the most important inputs in the process of calculating stock valuation.
For instance, the company can decide on a 5% increase in dividend each year. It is important to note that this 5% remains the same for the rest of life (as an assumption).
Discounting of the forecasted dividend growth
Discounting of the forecasted stream of dividends is done to bring values into today’s terms. This helps to assess the intrinsic valuation of the security in today’s terms. Discounting is done to make the valuation realistic because we compare calculated valuation under Gordon Growth Model with the current trading price.
The companies can use the cost of capital or required rate of return to discount the future’s dividend stream.
Constant growth dividend discount model
Gordon Growth Model is also termed as a constant growth model because it assumes a constant growth rate in the future stream of dividends. It’s one of the major assumptions for the Gordon model.
Gordon growth model terminal value
As we understand that this model assumes a future stream of dividends in perpetuity. It’s technically impossible to predict the dividend stream for the business’s whole (infinite) life. So, we make use of the perpetuity concept to calculate the dividend in the infinite life of the business. This value is called terminal value because we terminate cash flows at the time of incorporating terminal value.
Gordon growth model example
Suppose the current share price of the company is $105. The expected rate of growth is 5%, and the required rate of return is 5%. Suppose we apply the formula for the calculation of the Gordon growth model. We get a valuation amounting to $100. It means the intrinsic value of the company’s share is less than the current share price. Hence, the current share price is over-valued in the market. So, we do not recommend the purchase of the shares.