Gordon Growth Model

The Gordon Growth Model values stocks with perpetual stable growth assumptions. Formula integrates dividends, discount rate, and constant growth rate. It’s applicable to mature companies, reliant on accurate growth estimation, and finds value among income-focused investors.

Table of Contents

Characteristics:

• Constant Growth Assumption: The model assumes that dividends will grow at a constant rate indefinitely.
• Stable Growth Phase: Particularly suitable when a company’s growth enters a stable phase after initial expansion.

Formula:

• Key Components: The formula involves the Dividend Per Share, Discount Rate, and Constant Growth Rate.
• Value Calculation: The value of a stock is calculated using the equation Value = Dividend Per Share / (Discount Rate – Constant Growth Rate).

Calculation Process:

1. Identify Current Dividend: Determine the current dividend payment per share.
2. Estimate Growth Rate: Estimate the constant growth rate of dividends based on historical trends and industry conditions.
3. Determine Discount Rate: Identify the required rate of return, considering risk and market conditions.
4. Valuation: Apply the formula to calculate the intrinsic value of the stock.

Assumptions:

• Stable Dividends: The model assumes that dividends will continue to grow at the constant rate indefinitely.
• Consistent Earnings Payout: It presumes that the company will consistently distribute a portion of its earnings as dividends.

Limitations:

• Growth Assumption Dependency: Accuracy heavily relies on the assumption of perpetual and stable dividend growth, which might not always hold true.
• Market Factors Overlooked: The model might not account for sudden market changes that could impact growth rates and thus valuation.

Examples:

• Mature Companies Valuation: The model is often used to value well-established companies with stable dividend policies.
• Income-Oriented Assessment: It finds application in evaluating stocks that appeal to income-focused investors seeking reliable dividend income.

Key Highlights – Gordon Growth Model:

• Constant Growth Focus: Assumption of perpetual constant growth in dividends drives the model’s valuation approach.
• Intrinsic Value Formula: Integrates Dividend Per Share, Discount Rate, and Constant Growth Rate in the value calculation.
• Calculation Steps: Sequentially involves identifying current dividends, estimating growth rate, determining discount rate, and applying the formula.
• Assumption Clarity: Relies on stable dividends and consistent earnings payout assumptions.
• Accuracy Considerations: Accuracy hinges on stable growth assumption and might overlook sudden market shifts.
• Application Spectrum: Useful for valuing mature firms and attracting income-seeking investors.

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