What is the Gordon Growth Model?

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 stock’s intrinsic value equals the sum of the present value of the future dividend. We note from the above graph companies like McDonald’s, Procter & Gamble, Kimberly Clark, PepsiCo, 3M, Coca-Cola, Johnson & Johnson, AT&T, and Walmart pay regular dividends. Therefore, we can use the Gordon growth model to value such companies.

There are two basic types of the model: the stable and multistage growth models. The stable model assumes that the dividend growth is constant over time. However, the multistage growth model does not think of the constant growth of dividends. Hence, we have to evaluate each year’s dividend separately. However, eventually, the multistage model assumes constant dividend growth.

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

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 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 moreke: 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 moreg: expected dividend growth rate (assumed to be constant)

The other assumptions of the Gordon growth formula are as follows: –

  • We believe that the company will grow at a constant rate.The company has stable financial leverage or no financial leverageFinancial LeverageFinancial 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 company’s free cash flow 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 us assume that ABC Co. will pay a $5 dividend next year, which is expected to grow at 3% yearly. Further, the required rate of return for the investor is 8%. So, what is the intrinsic value of the ABC Co. 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:

Note that we have assumed a constant growth of dividends over the years. It could be true for stable companies. However, 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. If the stock is trading at, e.g., $70, it is undervalued. On the other hand, if the stock is trading at $120, it is overvalued.

Walmart Stable Dividends

Let us look at Walmart’s dividends paid in the last 30 years. Walmart is a mature company. However, 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 multistage example of a company wherein we have the following: – 

  • Current Dividends (2016) = $12Growth in Dividends for 4 years = 20%Growth in Dividends after 4 years = 8%Cost of EquityCost Of EquityCost 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 will 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 the Gordon growth model for terminal value. We note that the growth stabilizes after 2020. Therefore, using this model, we can calculate the Gordon growth model terminal value in 2020. 

It can be estimated using the Gordon Growth Formula –

As seen below, we have applied the Excel formula to obtain the 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 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 below. Please note that the required rate of return in this example 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 the Terminal Value

We already know that the stock’s intrinsic value is the present value of its future cash flows. Now, since we have calculated the present value of dividends and the 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 total of both will reflect the fair valueFair ValueThe fair value of an investment is the asset sale price that is agreeable to both the buyer and the seller. There is a caveat; the amount should be agreeable in a free trade scenario; there should be no external pressure or conditions.read more of the stock.

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

Fair Value comes to $273.0

Advantages

  • Gordon’s growth model is beneficial for stable companies. Companies with good cash flow and limited business expensesBusiness ExpensesBusiness expenses are those incurred in order to successfully run, operate, and maintain a business. Travel & conveyance, salaries, rent, entertainment, telephone and internet expenses are all examples of business expenses.read more.The valuation model is simple and easy to understand with its inputs available or can be assumed from the company’s financial statements and annual reports of the CompanyAnnual Reports Of The CompanyAn 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 evaluate or compare companies of different sizes and industries.The model is widely used in the real estate industry by real estate investors and agents whose 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 development throughout their life due to different market conditions, business cyclesBusiness CyclesThe business cycle refers to the alternating phases of economic growth and decline.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 company’s size, brand value, market perception, and local and geopolitical factors. All these factors affect the actual stock value; hence, the model does not provide a holistic picture of the intrinsic stock value.The model cannot be used for companies with irregular cash flows, dividend patterns, or financial leverage.The model cannot be used for companies in the growing stage with no dividend history, or one can use it with more assumptions.

Conclusion

Although Gordon’s growth model is simple to understand, it is based on several critical assumptions. Thus, it has its limitations. However, the model can be used for stable companies having a history of dividend payments and future growth. On the other hand, the multistage model can be used for more unpredictable companies by taking some more realistic assumptions into account.

Gordon Growth Model Video

This article is a guide to Gordon Growth Model. We discuss two valuation models: stable growth and multistage and Gordon Growth Model Terminal Value, practical examples and applications. You may also have a look at related articles on valuation: –

  • Excel Growth FormulaHeckscher Ohlin ModelDividend Growth Rate FormulaFree Cash Flow