﻿ Gordon growth model

# Gordon growth model

## Gordon growth model

Finding a stock’s true value remains crucial in the constantly changing world of financial analysis. The Gordon growth model is a crucial instrument that sheds light on this challenging endeavour. This technique, known as the gordon-shapiro or dividend discount model, or DDM, uses a stock’s anticipated future dividends to determine its intrinsic value. The key tenet of the concept, created by economists Myron J. Gordon and Eli Shapiro in the 1950s, is the idea of a steady dividend increase indefinitely.

This article delves into the fundamentals of the Gordon growth model, revealing its workings, exploring its formula, evaluating its merits and limitations, and providing specific examples to improve our understanding of this crucial tool in the world of stock valuation as we navigate the complex web of financial valuations.

## What is the Gordon growth model?

The Gordon growth model is a stock valuation method that aims to determine a stock’s fair value by considering its dividends and expected growth rate. This model was developed with the help of two economists from the 1950s, Myron J. Gordon and Eli Shapiro. It is based on the idea that a company’s dividends will grow continuously indefinitely. This fundamental presumption allows analysts to calculate the present value of all upcoming dividends and determine the stock’s intrinsic value.

## Understanding the Gordon growth model

The Gordon growth model, which offers a special lens to understand the essence of company valuation, ingeniously weaves the threads of finance and temporal value at its core. The perpetual growth assumption for dividends serves as the basis for this model’s operations, which assume an ongoing pattern of dividend growth. The approach is predicated on the idea that rising dividends in the future warrant a distinct valuation in terms of today’s value. The Gordon growth model captures the relationship between dividend growth, required return, and a stock’s intrinsic value by condensing finance’s intricacies into a straightforward formula. This understanding allows investors and analysts to fully understand the complex dance between dividends and valuation, allowing them to make well-informed investment decisions.

## Formula of Gordon growth model

The Gordon growth model’s mathematical formula is as follows:

Value of stock (P0) = D0 * (1 + g) / (r – g)

In the given equation:

P0: This value represents the stock’s intrinsic worth.

D0: Indicates the current dividend amount per share.

g: Indicates the dividend growth rate is constant.

R stands for the necessary rate of return or discount rate.

## Pros and cons of Gordon growth model

Like any financial tool, the Gordon growth model has advantages and disadvantages.

Pros:

• Simplicity

The formula for the model is simple and easy to understand, making it suitable for quick valuations.

• Emphasis on Dividends

The model emphasises dividends as a fundamental component of stock valuation, which is especially important for income-focused investors.

• Long-Term Utility

The model’s perpetual growth premise is appropriate for evaluating established businesses with reliable dividend practices.

Cons:

• Application Restrictions

The strategy best suits businesses with a track record of steady dividend increases. It might not be appropriate for newer or high-growth companies that don’t pay dividends.

• Constant Growth Assumption

The model’s reliance on a constant growth rate may only be accurate for some enterprises, leading to uncertain values.

• Sensitivity to Inputs

Accurate estimation is difficult because even small changes in growth and discount rates can result in significant changes in calculated intrinsic value.

## Examples of Gordon growth model

Consider the following examples to understand how the Gordon growth model might be used in real-world situations.

Company XYZ pays a \$US2 per share dividend now, with an estimated dividend growth rate of 5% and an 8% needed rate of return.

Using the Gordon growth model:

P0 = \$US2 * (1 + 0.05) / (0.08 – 0.05) =  \$US2.10 / 0.03 =  \$US70

The stock’s intrinsic value comes out to be \$US70 per share.

The Gordon growth model is a name for a financial valuation method. Assuming a steady growth rate and forecasting future dividends calculates a company’s intrinsic value. The model summarises this relationship in a straightforward formula and offers insights into how dividends, growth rates, and necessary returns affect a stock’s value.

The Gordon growth model may only be appropriate for some businesses. It functions best for businesses with a consistent payout history and predictable growth rates. The model’s assumptions can be questioned by young, high-growth businesses that don’t pay dividends or those with unpredictable payment patterns. It is not ideal for businesses that considerably deviate from continuous dividend growth because its effectiveness depends on a company’s attributes aligning with the model’s underlying assumptions.

The Gordon growth model is the best match for analysing well-established businesses with a track record of continuous dividend payments. Using it when predicting consistent, long-term growth rates is practical. It emphasises the importance of dividends and their growth in determining a stock’s value, making it a useful tool for investors looking to evaluate the intrinsic value of dividend-paying firms over the long run.

The current dividend per share (D0), the constant dividend growth rate (g), and the required rate of return (r) or discount rate (r) are the three main inputs needed by the Gordon growth model. The formula is shaped by these inputs as a whole, which enables analysts to calculate the intrinsic value of a stock based on its anticipated dividends and growth rate.

There are drawbacks to the Gordon growth model. It makes the unchanging assumptions of perpetual growth and a steady dividend growth rate, which may not apply to all businesses. The model is susceptible to estimation errors because its accuracy is very sensitive to variations in growth and discount rates. Additionally, it works best for businesses with a history of paying dividends, excluding those without. In some cases, these restrictions can result in incorrect appraisals.

## Category

### Read the Latest Market Journal

#### Introduction to unit trust

Published on Apr 23, 2024 25

In the diverse and complex world of investing, unit trusts stand out as a popular...

#### Back in Business: The Return of IPOs & Top Traded Counters in March 2024

Published on Apr 17, 2024 481

#### Weekly Updates 15/4/24 – 19/4/24

Published on Apr 15, 2024 72

This weekly update is designed to help you stay informed and relate economic and company...

#### From \$50 to \$100: Unveiling the Impact of Inflation

Published on Apr 12, 2024 155

In recent years, inflation has become a hot topic, evoking strong emotions as the cost...

#### Japan’s Economic Resurgence: Unveiling the Tailwinds Behind Nikkei 225’s Record Leap

Published on Apr 11, 2024 87

Source: eSignal, Intercontinental Exchange, Inc. In the heart of Japan’s economic landscape, the Nikkei 225...

#### Weekly Updates 8/4/24 – 12/4/24

Published on Apr 8, 2024 109

This weekly update is designed to help you stay informed and relate economic and...

#### What Makes Forex Trading Attractive?

Published on Apr 2, 2024 191

In a world where the click of a button can send goods across oceans and...

#### Weekly Updates 1/4/24 – 5/4/24

Published on Apr 1, 2024 99

This weekly update is designed to help you stay informed and relate economic and company...

POEMS 3 App

• Call Back

• Chat with us

Need Assistance? Share your Details and we’ll get back to you

IMPORTANT INFORMATION

This material is provided by Phillip Capital Management (S) Ltd (“PCM”) for general information only and does not constitute a recommendation, an offer to sell, or a solicitation of any offer to invest in any of the exchange-traded fund (“ETF”) or the unit trust (“Products”) mentioned herein. It does not have any regard to your specific investment objectives, financial situation and any of your particular needs. You should read the Prospectus and the accompanying Product Highlights Sheet (“PHS”) for key features, key risks and other important information of the Products and obtain advice from a financial adviser (“FA“) pursuant to a separate engagement before making a commitment to invest in the Products. In the event that you choose not to obtain advice from a FA, you should assess whether the Products are suitable for you before proceeding to invest. A copy of the Prospectus and PHS are available from PCM, any of its Participating Dealers (“PDs“) for the ETF, or any of its authorised distributors for the unit trust managed by PCM.

An ETF is not like a typical unit trust as the units of the ETF (the “Units“) are to be listed and traded like any share on the Singapore Exchange Securities Trading Limited (“SGX-ST”). Listing on the SGX-ST does not guarantee a liquid market for the Units which may be traded at prices above or below its NAV or may be suspended or delisted. Investors may buy or sell the Units on SGX-ST when it is listed. Investors cannot create or redeem Units directly with PCM and have no rights to request PCM to redeem or purchase their Units. Creation and redemption of Units are through PDs if investors are clients of the PDs, who have no obligation to agree to create or redeem Units on behalf of any investor and may impose terms and conditions in connection with such creation or redemption orders. Please refer to the Prospectus of the ETF for more details.

Investments are subject to investment risks including the possible loss of the principal amount invested. The purchase of a unit in a fund is not the same as placing your money on deposit with a bank or deposit-taking company. There is no guarantee as to the amount of capital invested or return received. The value of the units and the income accruing to the units may fall or rise. Past performance is not necessarily indicative of the future or likely performance of the Products. There can be no assurance that investment objectives will be achieved.

Where applicable, fund(s) may invest in financial derivatives and/or participate in securities lending and repurchase transactions for the purpose of hedging and/or efficient portfolio management, subject to the relevant regulatory requirements. PCM reserves the discretion to determine if currency exposure should be hedged actively, passively or not at all, in the best interest of the Products.

The regular dividend distributions, out of either income and/or capital, are not guaranteed and subject to PCM’s discretion. Past payout yields and payments do not represent future payout yields and payments. Such dividend distributions will reduce the available capital for reinvestment and may result in an immediate decrease in the net asset value (“NAV”) of the Products. Please refer to <www.phillipfunds.com> for more information in relation to the dividend distributions.

The information provided herein may be obtained or compiled from public and/or third party sources that PCM has no reason to believe are unreliable. Any opinion or view herein is an expression of belief of the individual author or the indicated source (as applicable) only. PCM makes no representation or warranty that such information is accurate, complete, verified or should be relied upon as such. The information does not constitute, and should not be used as a substitute for tax, legal or investment advice.

The information herein are not for any person in any jurisdiction or country where such distribution or availability for use would contravene any applicable law or regulation or would subject PCM to any registration or licensing requirement in such jurisdiction or country. The Products is not offered to U.S. Persons. PhillipCapital Group of Companies, including PCM, their affiliates and/or their officers, directors and/or employees may own or have positions in the Products. Any member of the PhillipCapital Group of Companies may have acted upon or used the information, analyses and opinions herein before they have been published.

This advertisement has not been reviewed by the Monetary Authority of Singapore.

Phillip Capital Management (S) Ltd (Co. Reg. No. 199905233W)
250 North Bridge Road #06-00, Raffles City Tower ,Singapore 179101
Tel: (65) 6230 8133 Fax: (65) 65383066 www.phillipfunds.com