The Gordon Growth Model (GGM), also known as the Gordon-Shapiro Model, is a method used to determine the intrinsic value of a stock. The model assumes that dividends will continue to increase at a constant rate indefinitely. This makes it particularly suitable for valuing companies with a stable dividend growth rate.
GGM Formula
At the heart of the GGM is a straightforward formula:
Where:
- \( P_0 \) is the current stock price.
- \( D_1 \) is the expected dividend next year.
- \( r \) is the required rate of return.
- \( g \) is the growth rate of the dividends.
Types of Gordon Growth Models
Constant Growth Model
This is the most basic form where it is assumed that dividends will grow at a constant rate \(g\).
Multi-Stage Growth Model
Used when companies have different growth rates for different time periods. Initially, dividends may grow rapidly and then stabilize to a constant rate.
Special Considerations
Assumption of Constant Growth
One of the main limitations of the GGM is the assumption of a constant growth rate, which may not hold true for companies in volatile industries.
Required Rate of Return
The required rate of return, \( r \), must be greater than the dividend growth rate, \( g \), to avoid a negative stock value which does not make practical sense.
Dividend Reinvestment
The model also assumes that all dividends are reinvested, which may not always be the case for all investors.
Practical Example
Suppose Company ABC is expected to pay a dividend of $2 next year, and its dividends are expected to grow at a rate of 3% indefinitely. If the required rate of return is 7%, the stock price \( P_0 \) can be calculated as follows:
So, the intrinsic value of the stock is $50.
Historical Context
The model was developed by Myron J. Gordon and Eli Shapiro in 1956. It is also referred to as the Gordon-Shapiro model in recognition of its creators.
Applicability in Modern Finance
The GGM is widely used in the fields of finance and investment, especially for companies with a stable growth rate in dividends. It helps investors make informed decisions by evaluating the fair value of a stock.
Comparing GGM with Other Models
Dividend Discount Model (DDM)
GGM is a specific form of the broader Dividend Discount Model, which also calculates the present value of expected future dividends.
Free Cash Flow Models
These models focus on free cash flow available to equity holders rather than dividends. They may be preferred in scenarios where companies do not pay consistent dividends.
Related Terms
- Discount Rate: The interest rate used in discounted cash flow analysis to present value future cash flows.
- Intrinsic Value: The perceived or calculated value of an asset, investment, or company, as opposed to its market value.
- Growth Rate: The rate at which a company’s dividends or earnings are expected to grow, typically expressed as a percentage.
FAQs
What is the primary use of the Gordon Growth Model?
Can the GGM be used for all companies?
How does the GGM handle fluctuating dividend growth rates?
References
- Gordon, M.J., & Shapiro, E. (1956). “Capital Equipment Analysis: The Required Rate of Profit.” Management Science, 3(1), 102-110.
- Damodaran, A. (2012). Investment Valuation: Tools and Techniques for Determining the Value of Any Asset. Wiley Finance.
- Penman, S.H. (2013). Financial Statement Analysis and Security Valuation. McGraw-Hill Education.
Summary
The Gordon Growth Model (GGM) offers a simplistic yet insightful approach for stock valuation based on future dividends growing at a constant rate. While it has its limitations, such as the assumption of constant growth, it remains an essential tool for investors and financial analysts in determining the intrinsic value of stocks with predictable dividend patterns.
