Gordon Growth Model

What is the Gordon Growth Model?

Gordon growth model is a type of dividend discount model in which not only the dividends are factored in and discounted but also a growth rate for the dividends is factored in and the stock price is calculated based on that.

Formula

As per the Gordon growth FormulaGordon Growth Formula Gordon Growth Model derives a company's intrinsic value if an investor keeps on receiving dividends with constant growth forever. The formula for Gordon growth model: P = D1/r-g (P = stock price, g = constant growth rate, r = rate of return, D1 = value of next year's dividend) read more, the intrinsic value of the stock is equal to the sum of all the present value of the future dividend. We note from the above graph, companies like McDonald’s, Procter & Gamble, Kimberly Clark, PepsiCo, 3M, CocaCola, Johnson & Johnson, AT&T, Walmart pay regular dividends, and we can use Gordon Growth Model to value such companies.

There are two basic types of the model – Stable Model and Multistage Growth Model. The stable model assumes that the dividend growth is constant over time; however multistage growth model does not assume constant growth of dividends, hence we have to evaluate each year’s dividend separately. However, eventually, the multistage model assumes a constant dividend growth.

Let us now see the Gordon growth formula and examples for each type of model and calculation of stock price:

Stable Gordon Growth Formula

Using a stable model, we get the value of the stock as below:

Where,

D₁: it is next year’s expected annual dividend per shareDividend Per Share Dividends per share are calculated by dividing the total amount of dividends paid out by the company over a year by the total number of average shares held.read more
ke: discount rate or the required rate of return estimated using the CAPMCAPM The Capital Asset Pricing Model (CAPM) defines the expected return from a portfolio of various securities with varying degrees of risk. It also considers the volatility of a particular security in relation to the market.read more
g: expected dividend growth rate (assumed to be constant)

Other assumptions of the Gordon Growth formula are as follows:-

We assume that the Company grows at a constant rate.
The Company has stable financial leverage, or there is no financial leverageFinancial Leverage Financial Leverage Ratio measures the impact of debt on the Company’s overall profitability. Moreover, high & low ratio implies high & low fixed business investment cost, respectively. read more involved in the Company.
The life of the firm is indefinite.
The required rate of return remains constant.
The free cash flow of the Company is paid as a dividend at constant growth rates.
The required rate of return is greater than the growth rate.

Stable Gordon Growth Model Example

Let’s assume that a Company ABC will pay a $ 5 dividend next year, which is expected to grow at the rate of 3% every year. Further, the required rate of return of the investor is 8%. What is the intrinsic value of the ABC Company stock?

Intrinsic Value FormulaIntrinsic Value Formula Intrinsic 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 of the stock using the Gordon growth model calculation:

Note, we have assumed a constant growth of dividends over the years. It could be true for stable Companies; however, the dividend growth could vary for growing/declining Companies. Hence we use the multistage model. Thus, using the stable model, the value of a stock is $ 100. Now, if the stock is trading at say $ 70, then it is undervalued, and if the stock is trading at $ 120, it is said to be overvalued.

Walmart Stable Dividends

Let us look at Walmart’s Dividends paid in the last 30 years. Walmart is a mature company, and we note that the dividends have steadily increased over this period. It means we can value Walmart using the Gordon Growth Model calculations.

source: ycharts

Multi-Stage Gordon Growth Model Example

Let us take a Gordon Growth Multi-Stage example of a company wherein we have the following –

Current Dividends (2016) = $12
Growth in Dividends for 4 years = 20%
Growth in Dividends after 4 years = 8%
Cost of EquityCost Of Equity Cost of equity is the percentage of returns payable by the company to its equity shareholders on their holdings. It is a parameter for the investors to decide whether an investment is rewarding or not; else, they may shift to other opportunities with higher returns.read more = 15%

Find the value of the firm using the Gordon Growth Model calculations.

Step 1: Calculate the dividends for each year till the stable growth rate is reached

Here we calculate the high growth dividends until 2020, as shown below.

The stable growth rate is achieved after 4 years. Hence, we calculate the Dividend profile until 2020.

Step 2: Calculate Gordon Growth Model Terminal Value (at the end of the high growth phase)

Here we will use Gordon Growth for Terminal Value. We note that the growth stabilizes after 2020; therefore, we can calculate the Gordon growth Model terminal value in 2020 using this model.

It can be estimated using the Gordon Growth Formula –

We apply the formula in excel, as seen below. TV or Terminal value at the end of the year 2020.

Gordon Growth Model Terminal value (2020) is $383.9

Step 3: Calculate the present valuePresent Value Present 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 of all the projected dividends

The present value of dividends during the high growth period (2017-2020) is given below. Please note that in this example, the required rate of return is 15%

Step 4: Find the present value of the Gordon Growth Model Terminal Value

Present value of Terminal value = $219.5

Step 5: Find the Fair Value – the PV of Projected Dividends and the PV of Terminal Value

As we already know that the intrinsic value of the stock is the present value of its future cash flows. Since we have calculated the Present value of Dividends and Present Value of Terminal ValueTerminal Value Terminal Value is the value of a project at a stage beyond which it's present value cannot be calculated. This value is the permanent value from there onwards. read more, the sum total of both will reflect the Fair Value of the Stock.

Fair Value = PV(projected dividends) + PV(terminal value)

Fair Value comes to $273.0

Advantages

Gordon’s growth model is highly useful for stable Companies; Companies that have good cash flow and limited business expenses.
The valuation model is simple and easy to understand with its inputs available or can be assumed from the financial statements and annual reports of the CompanyAnnual Reports Of The Company An annual report is a document that a corporation publishes for its internal and external stakeholders to describe the company's performance, financial information, and disclosures related to its operations. Over time, these reports have become legal and regulatory requirements.read more.
The model does not account for market conditions; hence it can be used to evaluate or compare Companies of different sizes and from various industries.
The model is widely used in the real estate industry by real estate investors, agents where the cash flows from rents, and their growth is known.

Disadvantages

Besides the above advantages of the Gordon Growth Model, there are a lot of disadvantages and limitations of the model as well:

The assumption of constant dividend growth is the main limitation of the model. It will be difficult for Companies to maintain continuous growth throughout their life due to different market conditions, business cyclesBusiness Cycles The business cycle represents the expansion and contraction of the economy that occurs due to ups and downs in the gross domestic product (GDP) of a country. It is experienced over the long term and goes parallel with the natural growth rate.read more, financial difficulties, etc.
If the required rate of return is less than the growth rate, the model may result in a negative value; thus, the model is ineffective in such cases.
The model does not account for market conditions or other non-dividend paying factors like the size of the Company, the brand value of the Company, market perception, local and geopolitical factors. All these factors affect the actual stock value, and hence, the model does not provide a holistic picture of the intrinsic stock value.
The model cannot be used for Companies that have irregular cash flows, dividend patterns, or financial leverage.
The model cannot be used for Companies in the growing stage that do not have any dividend history, or it has to be used with more assumptions.

Conclusion

Gordon’s growth model, although simple to understand, is based on a number of critical assumptions, thus has its own limitations. However, the model can be used for stable Companies having a history of dividend payments and future growth. For more unpredictable Companies, the multistage model could be used by taking into account some more realistic assumptions.

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