If you plan to start investing some money on the stock market, you have to be aware of the state of the stock at any time. This means you have to always pay attention to how it evolves. Sometimes, you have to perform some calculations. To avoid getting in too difficult matters, you should start studying the Gordon Growth Model.
What is the Gordon Growth Model?
The Gordon Growth Model also bears the name of dividend discount model. It represents a way to calculate the intrinsic value of a stock not taking into account the current value of the stock in question. This model is based on several future dividends, which we assume should grow constantly.
We take the general value of this dividend, that we have to pay over the years. Then, we assume this dividend should constantly grow at an unchanged rate. In the end, we obtain a current value for the upcoming series of dividends.
What is a dividend?
A dividend represents a part of a company’s total earnings. This portion is determined by the directors of the company, and they have to pay it to their shareholders. The payment can be done monthly or sometimes once every quarter of the year, but this decision belongs to the directors. It can consist of cash, stock shares, or any kind of material payment.
The formula of the Gordon Growth Model
This model is clearly illustrated through a mathematical formula. What we seek to find out is the stock value, so the formula will show us how to calculate it. The other elements present in the formula are D1, k, and g.
D1 is the value of the dividend per share that we expect to achieve in the upcoming year. K is the rate of return or discount rate necessary for the investor. G is the assumed growth rate of the dividend. As mentioned above, this is regarded as constant. In the end, the formula states that the stock value is equal with D1/(k-g).
What happens if the dividend doesn’t grow constantly?
Sometimes, after investors evaluate the dividend values, they might observe it’s not expected to grow in a constant manner. In this case, they have to separately include in the calculations the expected dividend growth for each year. However, at some point, this model also expects it to become constant.
How does the Gordon Growth Model work?
So, what is the Gordon Growth Model, after all? It represents, in fact, an assumption that the payments the company has to pay to its shareholders stay constant. This is the dividend per share (D1). Every year, this value increases at a certain rate. This is supposed to remain constant, and is marked as the growth rate in the equation (g).
Whenever investors buy a stock, they have to agree to a certain rate of return. This is marked by k, and is necessary to translate the unending dividend series into the present. Here is a practical example of how the formula can be applied.
Explaining the Gordon Growth Model practically
At first, we take a random company, and an initial dividend value that it agrees to pay next year. This value D1 is, let’s say, $1. Then, the assumption is that the dividend should increase by 5 percent (g). Then, we can assume that the needed rate of return will become 10 percent.
Therefore, the stock of this company trades $10 per share. With the help of the Gordon Growth Model, we can identify the intrinsic value of one share. Here’s the formula:
According to the Gordon Growth Model, one stock is worth $20. However, the company sells them for $10. It has underappreciated the value of its stock, so it should change its market strategy.
Disadvantages of the Gordon Growth Model
What is the Gordon Growth Model? An assumption, which isn’t always realistic. It is based on the idea of constant growth, which isn’t always the case on the stock market. Companies undergo different cycles, and the business actually fluctuates. They can either suffer a sudden loss or earn more than usual, which affects this constant growth.
One more drawback is purely mathematical, but extremely important. In some cases, this model might be seen as useless. Let’s say the rate of return has a lower value than the actual growth rate of the dividend. In this case, the obtained result is negative, and not realistic at all.
The same mathematical difficulty arises if these two values are equal. What we get is a result which tends toward infinity. Again, this does not reflect reality, and might prove the Gordon Growth Model unreliable.
Sometimes, this model might undervalue the actual growth rate of some companies. This is one reason why some investors avoid using it. Making the needed estimates can be difficult, and the results are sometimes not even fulfilling. However, the model is still useful if you want to see where your company is situated.
Like all economic models, the Gordon Growth Model has disadvantages. However, it is still widely used in fields like real estate or banking. This happens since these industries experience a growth that stays pretty constant. In the end, the resulting errors are not that big, and the model becomes reliable.
The Gordon Growth Model is one of the easiest ways to calculate the value of your shares. Although it looks a bit complicated, you can easily obtain the needed results if you can accurately assess the rate of return. Despite the visible disadvantages, the model is still useful if you are a beginner in the investment field.
Even if you’re not new to this industry, the Gordon Growth Model can still help you. The results can help investors make comparisons between companies from the same field, or even from different areas. This way, they can see where their business is situated in the market, and shape their strategies accordingly.