Gordon Growth Model to Value Stocks Explained: When we try and find the value of stock we generally refer to the stock exchange. But the values provided by a stock may be subject to many influences that may have nothing to do with the financial aspect of the company in question. We also come across companies that have performed poorly in the past but still hold on to their stock price or surge higher simply based on market speculation.
In such cases, how can we find out a reliable intrinsic value (inherent value of an asset) of a stock? Today focussing on this aspect we discuss the Gordon Growth Model, a valuation tool that enables us to calculate the value of a stock exclusive of the current market conditions.
The Gordon Growth Model is named after Myron J. Gordon due to his work on the model along with Eli Shapiro in 1956. The model however heavily borrows theoretical and mathematical ideas from John Burr William’s book “ The Theory on Investment Value”.
How does the Gordon Growth Model Work?
The Gordon Growth Model aka the dividend Discount Model is a stock valuation method that calculates the intrinsic value of a stock. This is done based on the theory that the value on the stock is worth the sum of the present value of all future dividend payments it may generate.
If the value of the stock obtained from the model is higher than the current trading price then the stock is considered to be undervalued. On the other hand, if the value obtained from the model is higher then the stock is considered to be overvalued.
Assumptions under Gordon Growth Model
The Gordon Growth Model works based on the following assumptions
- The company follows a stable business model with no significant changes in its operations
- The growth rate of the company is constant
- The company pays out all free cash flow as a dividend
Formula of Gordon Growth Model to find IV
In order to find the value of stocks, here is the Gordon Growth Model Formula
Value of stock as per GGM= D1 / (r – g)
- D1 = Expected Dividend per share one year from now.
- g = Expected Dividend Growth rate which is constant for perpetuity.
- r = Rate of return an investor expects
Example of GGM Application
Say you are trying to find out the Intrinsic value of stock ABC which is currently trading at Rs. 25 per share and will pay a dividend of Rs. 1/per share the next year and this dividend is expected to increase at 5% constantly hereafter. Also, say you are looking for a 10% return on the security you invest in.
D1 = 1
g = 5%
r = 10%
Therefore Intrinsic value of ABC = 1/ .10-.05
Solving this we would arrive at Rs.20. If we take a look at the ABC’s trading price i.e. Rs.25 we find out that the stock is overvalued as per GGM. All things remaining the same say ABC was trading at Rs. 18. In this case, the stock would be undervalued and it would be wise to invest.
Limitations of the Gordon Growth Model
1. The modal assumes that the company will keep paying a dividend at a constantly increasing growth rate (g) forever. In-depth market knowledge is not required to know that any company cannot keep paying increasing dividends forever. Take the current scenario in the COVID-19 environment where even companies that were booming at the start of the year are now bracing themselves.
Then come the companies that do not pay a dividend at all. It may surprise you that companies like Alphabet Inc, Amazon.com Inc, Facebook Inc have never paid cash dividends. According to the GGM, a company that does not pay a dividend is worthless.
Investors, however, have used the Modigliani- Miller hypothesis in order to combat this problem. Here they replace ‘D’ with ‘E’ which stands for Earnings per share.
2. Another issue arises due to mathematical reasons with respect to the growth rate(g) and expected RoR. The Growth rate(g) cannot exceed the RoR. If it does so then the intrinsic value of the stock would be negative. The Growth rate(g) also cannot be equal to the RoR. If this happens the intrinsic value will result in infinity which is unrealistic. This leads to investors increasing their expected RoR just to satisfy the criterion.
3. GGM ignores every market condition that in real life would still have a significant impact on the value of a stock. These include brand names, customer loyalty, unique intellectual property, and other non-dividend value-enhancing characteristics.
Fixing the limitation of Constant Growth Expectation in GGM
The unrealistic expectation set for dividends to not only be paid every year but also at a constantly increasing rate. This has given way to the Multistage Growth Model of the GGM.
The Multistage Growth Model of the GGM works similarly but considers multiple expected dividend growth rates. Let us understand this better with an example
Example of Multistage Growth Model
Say the same stock ABC trading at Rs. 25 per share, paying a dividend of Rs. 1/ share the next year. But in addition, we have the growth rates for the next 3 years which are 7%, 10%, and 12% followed by a steady increase o 5% in perpetuity.
To find the intrinsic value we are first to take the dividend growth rates and calculate the actual dividend for the following years.
D1 = $1.00
k = 10%
g1 (dividend growth rate, year 1) = 7%
g2 (dividend growth rate, year 2) = 10%
g3 (dividend growth rate, year 3) = 12%
gn (dividend growth rate thereafter) = 5%
Therefore the dividends for the following years are:
D1 = $1.00
D2 = $1.00 * 1.07 = $1.07
D3 = $1.07 * 1.10 = $1.18
D4 = $1.18 * 1.12 = $1.32
We are then supposed to calculate the present value of each dividend during the unusual growth period:
$1.00 / (1.10) = $0.91
$1.07 / (1.10)^2 = $0.88
$1.18 / (1.10)^3 = $0.89
$1.32 / (1.10)^4 = $0.90
Then, we value the dividends occurring in the stable growth period, starting by calculating the fifth year’s dividend:
D5 = Rs.1.32*(1.05) = Rs.1.39
We then apply the stable-growth Gordon Growth Model formula to these dividends to determine their value in the fifth year:
Rs.1.39 / (0.10-0.05) = Rs.27.80
The present value of these stable growth period dividends are then calculated:
Rs.27.80 / (1.10)5 = Rs.17.26
Finally, we can add the present values of Company XYZ’s future dividends to arrive at the current intrinsic value of Company XYZ stock:
Rs.0.91+Rs.0.88+Rs.0.89+Rs.0.90+Rs.17.26 = Rs.20.84
The multistage growth model also indicates that Company XYZ stock is overvalued (an Rs.20.84 intrinsic value, compared with an Rs.25 trading price).
The Gordon Growth Model is a straightforward approach to value stocks, but it comes with multiple limitations as discussed above. We can even see that even though the multistage Growth Model of the GGM addresses the problems of constant growth that is expected in the GGM it still does not make it more in tune with the real world.
Despite this, the GGM is widely used by analysts worldwide. This can be primarily attributed to the fact that GGM also enables a comparison of companies in different industries primarily because the GGM excludes other market conditions. Making its very weaknesses part of its strengths. Therefore GGM should not be the only method used for valuing stocks. And if used it should be done in instances where other models fail.
Aron, Bachelors in Commerce from Mangalore University, entered the world of Equity research to explore his interests in financial markets. Outside of work, you can catch him binging on a show, supporting RCB, and dreaming of visiting Kasol soon. He also believes that eating kid’s ice-cream is the best way to teach them taxes.