What is Gordon Growth Model?
1111 reads · Last updated: December 5, 2024
The Gordon growth model (GGM) is a formula used to determine the intrinsic value of a stock based on a future series of dividends that grow at a constant rate. It is a popular and straightforward variant of the dividend discount model (DDM). The GGM assumes that dividends grow at a constant rate in perpetuity and solves for the present value of the infinite series of future dividends.Because the model assumes a constant growth rate, it is generally only used for companies with stable growth rates in dividends per share.
Definition
The Gordon Growth Model (GGM) is a formula used to determine the intrinsic value of a stock based on a series of future dividends that grow at a constant rate. It is a popular and straightforward variant of the Dividend Discount Model (DDM). GGM assumes that dividends grow at a perpetual constant rate and solves for the present value of an infinite series of future dividends. This model is typically used only for companies with stable dividend growth rates due to its constant growth rate assumption.
Origin
The Gordon Growth Model was introduced by American economist Myron J. Gordon in the 1950s. It is a simplification of the Dividend Discount Model, focusing on companies with relatively stable dividend growth rates. The model was detailed in a paper co-authored by Gordon and Eli Shapiro in 1962.
Categories and Features
The Gordon Growth Model is primarily applicable to two types of companies: mature companies with stable dividend growth and companies with predictable growth patterns. Its main features include the assumption of constant dividend growth, making it suitable for long-term investment analysis. The advantages are its simplicity and ease of use, while the disadvantages include strict assumptions about growth and discount rates, which may not be suitable for companies with volatile growth.
Case Studies
A typical case is The Coca-Cola Company, which has had a relatively stable dividend growth rate over the years, making it suitable for valuation using GGM. Assuming Coca-Cola's dividend growth rate is 5% and the discount rate is 8%, its intrinsic stock value can be calculated using the GGM formula. Another example is Procter & Gamble, whose long-term stable dividend growth makes GGM an effective tool for evaluating its stock value.
Common Issues
Common issues investors face when using the Gordon Growth Model include how to accurately predict the dividend growth rate and discount rate. What if the company's dividend growth is unstable? It is generally recommended that investors use GGM only when a company's dividend growth rate is stable and predictable. Additionally, investors should be aware of the model's sensitivity to growth and discount rates.
