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 FormulaGordon 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.

Dividend Yield Chart

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:

Gordon Growth Model Formula

Where,

  1. D1: it is next year’s expected annual dividend per shareDividend Per ShareDividends 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
  2. ke: discount rate or the required rate of return estimated using the CAPMCAPMThe 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
  3. g: expected dividend growth rate (assumed to be constant)

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

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 FormulaIntrinsic 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:

stable model

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.

WallMart Steady Dividend Paid - 1

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 –

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.

Two Stage - Example - Part 1

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 –

DDM to calculate Terminal Value

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

Two Stage - Example - Part 2

Step 3: Calculate the 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 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%

Two Stage - Example - Part 3

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

Present value of Terminal value = $219.5

Two Stage - Example - Part 4

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 ValueTerminal 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

Two Stage - Example - Part 5

Advantages

Disadvantages

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

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.

Gordon Growth Model Video

 

This article has been a guide to the Gordon Growth Model. Here we look at the two types of valuation models – stable growth and multi-stage models along with its assumptions, practical examples, and applications. You may also have a look at related articles on Valuation –