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The Gordon Growth Model

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The Gordon Growth Model

The Gordon growth model is also referred to as the DDM (dividend discount model). It is a model used to determine the intrinsic stock value based mainly on a future sequence of dividends, which grow normally at a rate, which is constant. Thus, it is a method of valuing the stock price for a company based on the assumption that the worth of its stock is the sum total of its payments for future dividend, which are discounted back mainly to their current value. In essence, the Gordon growth model is utilized to value stocks on the foundation of their future dividends net present value (Investopedia, 2015).

It is paramount to note that the DDM model calculates the fundamental stock value, exclusive of present market conditions. Consequently, the model equates this particular value mainly to the current value of the future dividends of a stock. This model is applicable whereby a dividend per share which is payable annually is provided and the assumption is that the dividend will grow at a rate which is constant in perpetuity; the Gordon growth model will solve the current value of the immeasurable sequence of future dividends (InvestingAnswers, 2015).

The Gordon growth model was named after Professor Myron Gordon, who was a financial scholar in the 1960s although he was not scholar to promote the model. Notably, John Burr Williams and Robert F. Weise also produced substantial work in this particular area. Evidently, there are mainly two basic types of the DDM model, which include the multistage model and the stable model (Investopedia, 2015).

The Stable Model

P (Stock Value) = D

K – G

Where:

D = dividend per share that is expected next year

K = required ROR (rate of return) or discount rate for investors which can be projected using the CAP (Capital Asset Pricing) model

G = rate in dividends growth (in perpetuity) which is presumed to be constant

Multistage Growth Model

In this particular model, there are no expectations that the dividends will grow mainly at a rate, which is constant. Thus, the investor should evaluate the dividends for each year separately and incorporate the probable dividend growth rate for each year. However, this model has an assumption that the dividend growth will eventually become constant (InvestingAnswers, 2015).

The Gordon growth model application

For an investor to apply this model, he/she must first know the dividend payment for the year and then approximate its future projected growth rate. Majority of investors unfortunately analyze the historic growth rate for the dividend and then make assumptions that its future growth shall be in comparison to the past growth. However, estimating the required ROR (rate of return) for the stock, which is also referred to as the cost of capital or the hurdle rate, is very challenging since it needs a lot of information. In addition, determining a company’s fair value means using the DCFA (Discounted Cash Flow Analysis) which is applicable in this model (Investopedia, 2015).

References

InvestingAnswers. (2015). Gordon Growth Model. Retrieved on 1st April 2015 from < http://www.investinganswers.com/financial-dictionary/income-dividends/gordon-growth-model-5270 >

Investopedia. (2015). Gordon Growth Model. Retrieved on 1st April 2015 from < http://www.investopedia.com/terms/g/gordongrowthmodel.asp >