Gordon Growth Model

a.  Gordon’s growth model is similar to the basic dividend discount model, except that it has the provisions for the growth in dividends.

b.  This model is also called the two-stage dividend discount model. This model allows for the growth or change of dividend over time.

c.  This model assumes that dividends grow indefinitely at a constant growth rate. Thus, this model is most appropriate for the non-cyclical and matured companies, as these companies have fairly stabilized and constant growth.

d.  The intrinsic value of the company as per the Gordon Growth Model is:

Another assumption of this model is that the ‘r’, i.e. the required rate of return is always higher than ‘g’, i.e. the growth rate of dividends.
Also, as per this model:

D₁ is the dividend in the next period.
Therefore,

e.  The growth rate of dividend, i.e. ‘g’ is nothing but the ‘earnings retention rate’ times the ‘return on equity’.

Alternatively, the analysts can also use the historical trends data or the median industry dividend growth rate to estimate the growth.

f.  The Gordon Growth Model is extremely sensitive to the changes in both r and g.

g.  In this model, as the ‘r’ approaches ‘g’ the intrinsic value of the stock increases dramatically; hence, the basic requirement of this model is that the ‘g’ must be strictly lower than the ‘r’.

h.  Thus, some of the main assumptions of this model are:

     i.  The dividends are the correct metric for valuation purposes;

    ii.  The ‘g’, i.e. the growth rate of dividend is constant and perpetual and it never changes;

   iii.  The required rate of return, i.e. ‘r’ is also constant over time; and

   iv.  The ‘g’ is significantly less than ‘r’.

i.  Some of the main alternatives to using the Gordon Growth Model are:

     i.  Modifying the model for the varying pattern of growth;

    ii.  Using cash flow as a measure rather than dividends, especially for the non-dividend paying stocks; and

   iii.  Using some other approach.

For Example:

Suppose there is a stock, which is currently paying a dividend at $ 1 per year per share. This dividend is expected to grow at the rate of 4% per annum, infinitely. The required rate of return of the stock is 6%. We have to calculate the intrinsic value of the stock.

We are given the following information:

The intrinsic value of the stock would be:

or,

V₀ = [1(1 + 0.04)] / [0.06 – 0.04] = $52