What is the Gordon Growth Model?

1. What is the Gordon Growth Model? The Gordon Growth Model (GGM) is a model used to calculate the intrinsic stock value based on the infinite value of future dividends discounted in its present value. This model disregards the stock market price and focuses more on what value it could give in the future. GGM assumes a constant return rate for dividends, which can be used for computing the intrinsic stock value of established companies. Other assumptions for this model are that the company has stable financial leverage, and the free cash flows are paid as dividends. Gordon growth model assumes that the business will continually pay dividends in constant growth in perpetuity. In computing the intrinsic value, the model takes the infinite future value of dividends in its present value by discounting back using the expected return rate. It is irrespective of the stock's current value and only considers the dividend payout factor, rate of return, and the expected constant growth rate. So, if the current market value is higher than the intrinsic value, it means that the stock price is overvalued and vice versa. Some limitations, however, are that no company pay dividends at a constant growth.It do not consider that free cash flows might be used for business expansion at some point rather than distributed as dividends to its shareholders. Also, having a higher growth rate than the expected return rate would result in a negative value; while a growth rate equals to rate of return can provide an infinite value of a stock. Gordon Growth Model Formula and Example eFinancial Models Zurich, Switzerland 8000 info@efinancialmodels.com https://www.efinancialmodels.com/

2. What is the Gordon Growth Model? Shown below is the formula for the Gordon growth model: P = D1/(r-g) Wherein: P = Intrinsic Value D1 = Expected Annual Dividend per Share for the Following Year R = Required Rate of Return g = Constant Growth of Dividend, in perpetuity Example: Given that the company's stock price is trading at $55 per share, investors' expected rate of return is 8%, with an annual growth rate of 4%. The dividend to be paid per share next year is $2. The company’s stock intrinsic value is computed as follow: P = D1/(r-g) P = 2/ (8%-4%) P = $50 The intrinsic value is computed at $50, which means that the current company's stock is overvalued by $5. Gordon growth model can compare the intrinsic value of a company to industry standard and peer's benchmark. It can also be used to evaluate the intrinsic value to its current market price, which can be a basis for investing or not in the company. However, there are limitations to this model due to its sensitivity to the discount factor and growth rate. It can either provide a negative value if the growth rate is higher than the discount rate or an infinite value of a share if the rate of return equals the growth rate. The Gordon growth model can be utilized to evaluate stock prices with other market values such as the Price to Earnings Ratio, Earnings per Share, and Book Value per Share. eFinancial Models Zurich, Switzerland 8000 info@efinancialmodels.com https://www.efinancialmodels.com/