Understanding Gordon Growth Model
One of the most trusted financial models, Gordon Growth Model is employed in order to estimate the intrinsic value of a stock today on the basis of the stock’s expected future dividends.
The model is used by various economists, market investors and analysts so as to compare the value of stock against its actual price in the market.
On calculation, a difference arrives between two values that helps in estimating whether stock is under or over valued by the market.
It must be mentioned here that the growth model concentrates only on the effects of the future dividends. Other factors including sentiments of investors and market competition etc. which bear an effect on the market price of the stock are ignored.
It is recommended to use the model for estimating stock value of large, stable and well-established companies which share a track record of providing predictable rate of dividend growth.
P = D1 / (k-g)
P = Stock value based on model
D1 = Expected dividend/share one year from now
k = Required rate of return for a equity investor
G = Growth rate in dividends (in perpetuity)
For instance, stock of company X is valued at Rs. 10/ share and pays out a Rs. 1 dividend/ share consistently and also predicts that its dividend will rise by 5 per cent per year.
Investor’s required rate of return is 10 percent.
P = Rs.1 / (.10 – .05) = 20
The model says the stock is worth $20. This means it’s Rs. 10 more than the market price. Therefore, the stock is undervalued by the market. So, investors must buy it.