Gordon Growth Model Formula
Gordon Growth Model Formula is used to find the intrinsic value of the companyFind The Intrinsic Value Of The CompanyIntrinsic value is defined as the net present value of all future free cash flows to equity (FCFE) generated by a company over the course of its existence. It reflects the true value of the company that underlies the stock, i.e. the amount of money that might be received if the company and all of its assets were sold today.read more by discounting the future dividend payouts of the company.
There are two formulas of Growth Growth ModelGrowth Growth ModelGordon Growth Model is a Dividend Discount Model variant used for stock price calculation as per the Net Present Value (NPV) of its future dividends. read more
We will look at both the formulas one by one
#1 – Gordon Growth Model Formula with Constant Growth in Future Dividends
The Gordon growth model formula that with the constant growth rate in future dividends is as per below.
Let’s have a look at the formula first –
Here,
- P0 = Stock Price;
- Div1= Estimated dividends for the next period;
- r = Required Rate of Return;
- g = Growth Rate
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For eg:
Source: Gordon Growth Model Formula (wallstreetmojo.com)
Explanation
In the above formula, we have two different components.
The first component of the formula is the estimated dividends for the next period. To find out the estimated dividends, you need to look at the historical data and find out the past growth rate. You can also take help from financial analysts and the projections they make. The estimated dividends won’t be accurate, but the idea is to predict something that is closer to the actual future dividends.
The second component has two parts – the growth rate and the required rate of return.
To find out the growth rate, we need to use the following formula –
Growth Rate = Retention Ratio * ROE
As you already know, if we divide the retained earningsRetained EarningsRetained Earnings are defined as the cumulative earnings earned by the company till the date after adjusting for the distribution of the dividend or the other distributions to the investors of the company. It is shown as the part of owner’s equity in the liability side of the balance sheet of the company.read more by net income, we would get the retention ratioRetention RatioRetention ratio indicates the percentage of a company’s earnings which is not paid out as dividends but credited back as retained earnings. This ratio highlights how much of the profit is being retained as profits towards the development of the firm.read more, or else, we can also use (1 – Dividend Payout RatioDividend Payout RatioThe dividend payout ratio is the ratio between the total amount of dividends paid (preferred and normal dividend) to the company's net income. Formula = Dividends/Net Incomeread more) to find out the retention ratio.
And ROE is the return on equityROE Is The Return On EquityReturn on Equity (ROE) represents financial performance of a company. It is calculated as the net income divided by the shareholders equity. ROE signifies the efficiency in which the company is using assets to make profit.read more (net income/shareholders’ equity)
To find out the required rate of return, we can use the following formula –
r = (D / P0) + g
In other terms, we can find require the rate of returnRequire The Rate Of ReturnRequired Rate of Return (RRR), also known as Hurdle Rate, is the minimum capital amount or return that an investor expects to receive from an investment. It is determined by, Required Rate of Return = (Expected Dividend Payment/Existing Stock Price) + Dividend Growth Rateread more just by adding a dividend yield and the growth rate.
Use of Constant Rate Gordon Growth Model
By using this formula, we will be able to understand the present stock price of a company. If we look at both of the components in the formula, we will see that we are using a similar present valuePresent ValuePresent Value (PV) is the today's value of money you expect to get from future income. It is computed as the sum of future investment returns discounted at a certain rate of return expectation.read more method to find out the stock price.
First, we are calculating the estimated dividends. Then, we are dividing it by the difference between the required rate of return and the growth rate. That means the discounting rate in this regard is the difference between the required rate of return and the growth rate. By dividing the same, we can easily find out the present value of the stock price.
Calculation Example of the Gordon Growth Model with Constant Growth
Hi-Fi Company has the following information –
- Estimated dividends for the next period – $40,000
- The required rate of return – 8%
- Growth rate – 4%
Find out the stock price of Hi-Fi Company.
In the above example, we know the estimated dividends, growth rate, and also required a rate of return.
By using the stock – PV with constant growth formula, we get –
- P0 = Div1 / (r – g)
- Or, P0 = $40,000 / (8% – 4%)
- Or, P0 = $40,000 / 4%
- Or, P0 = $40,000 * 100/4 = $10, 00,000.
By simply using the above formula, we will be able to find out the present stock price. It can be a great tool for the investors and the management of any company. One thing we should notice here is that the stock price is the total stock price since we assumed the estimated dividends for all the shareholders. By simply taking the number of shares into account, we would be able to find out the stock price per share.
Gordon Growth Model Calculator
You can use the following Stock – PV with Constant Growth Calculator.
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Gordon Growth Model Formula in Excel (with excel template)
Let us now do the same example above in Excel. This is very simple. You need to provide the three inputs of Dividends, Rate of Return, and Growth Rate.
You can easily find out the stock price of the company in the template provided.
You can download this Gordon Growth Model Formula template here – Gordon Growth Model Formula with Constant Growth Excel Template
#2 – Gordon Growth Formula with Zero Growth in Future Dividends
The only difference in this formula is the “Growth factor.”
Here’s the formula –
Here, P = Price of the Stock; r = required rate of return
Explanation
This formula is based on the dividend discount model.
Thus, we place the estimated dividends in the numerator and the required rate of return in the denominator.
Since we are calculating with zero growth, we will skip the growth factor. And as a result, the required rate of return would be the discounting rate. For example, if we assume that a company would pay $100 as a dividend in the next period, and the required rate of return is 10%, then the price of the stock would be $1000.
One thing we should keep in mind while calculating the formula is the period we use for the calculation. The period of the dividends should be similar to the period of the required rate of return.
So, if you consider the annual dividends, you need to also take the required annual rate of return to maintain the integrity in the calculation. For calculating the required rate of return, we will dividend yieldDividend YieldDividend yield ratio is the ratio of a company's current dividend to its current share price. It represents the potential return on investment for a given stock.read more into consideration (r = Dividends / Price). And that we can find out by using the historical data. The required rate of return is the minimum rate that the investors would accept.
Use of the Gordon Growth Model Formula (Zero Growth)
In this formula, it is estimated dividends for the next period. And the discounting rate is the required rate of return, i.e., the rate of return that the investors accept. There are various methods by using which the investors and the financial analysts can find out the present value of the stock, but this formula is the most fundamental of all.
Thus, before investing in the company, every investor should use this formula to find out the present value of the stock.
Calculation Example of Gordon Growth Model (Zero Growth)
Let’s take an example to illustrate Gordon Growth Model Formula with Zero Growth Rate
Big Brothers Inc. has the following information for every investor –
- The estimated dividends for the next period – $50,000
- The required rate of return – 10%
Find out the price of the stock.
By using the Stock – PV with Zero Growth Formula, we get –
- P = Dividend / r
- Or, P = $50,000 / 10% = $500,000.
- The stock price would $500,000.
One thing you should notice here is that $500,000 is the total market price of the stock. And depending on the number of outstanding shares, we would find out the price per share.
In this case, let’s say that the outstanding sharesOutstanding SharesOutstanding shares are the stocks available with the company's shareholders at a given point of time after excluding the shares that the entity had repurchased. It is shown as a part of the owner's equity in the liability side of the company's balance sheet.read more is 50,000.
That means the stock price would be = ($500,000 / 50,000) = $10 per share.
Gordon Zero Growth Calculator
You can use the following Gordon Zero Growth Rate Calculator
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Gordon Zero Growth Formula in Excel (with excel template)
Let us now do the same example above in Excel. This is very simple. You need to provide the two inputs of Dividend and Rate of Return.
You can easily find out the price of the stock in the template provided.
Recommended Articles
This article has been a guide to Gordon Growth Model Formula. Here we discuss the two types of Gordon Growth formulas, including constant growth and zero growth, along with its uses practical examples and calculations. You may learn more about valuations from the following articles –
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