VMC: What is the Gordon Growth Model?
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Definition of the Gordon Growth Model
- The Gordon growth model, or GGM, is used to calculate the intrinsic value of a stock from future dividends.
- The model only works for companies that pay out dividends, which have a constant growth rate.
What Impacts the Gordon Growth Model?
- The required rate of return
- Dividend
- Dividend growth rate
How to Calculate the Gordon Growth Model?
- The intrinsic value of an equity is calculated by dividing the value of the next year’s dividend by rate of return less the growth rate.
P = D1/r – g
(Where P = current stock price, D1 = value of next year’s dividend, g = constant growth rate expected, and r = required rate of return.)
Why is the Gordon Growth Model Important?
- Compared to other valuation methods, the Gordon growth model is much more straightforward to calculate.
- The Gordon growth model helps investors see whether the stocks are undervalued or overvalued.
- With this model, the investors would make a more rational choice when trading stocks.
The Gordon Growth Model in Practice
- For example, if a company lists its stock price at $50, has a required rate of return at 15% (r), pays a dividend of $1 per share you own, and has a constant growth rate of 6% then how would you calculate the stock value?
- $1 ÷ (0.15 – 0.06) = $11.11
- The model would not be practical if the growth rate is equal or more than the required rate of return.
- It is almost impossible for firms to have a constant growth rate over a long period, which violates the assumptions of GGM.
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DISCLAIMER: This content is for information purposes only. It is not intended to be investment advice. Readers should not consider statements made by the author(s) as formal recommendations and should consult their financial advisor before making any investment decisions. While the information provided is believed to be accurate, it may include errors or inaccuracies. The author(s) cannot be held liable for any actions taken as a result of reading this article.