Gordon Growth Model

Definition

The Gordon growth model is a valuation method used to determine the intrinsic value of a stock by estimating the present value of its future dividend payments. It is based on the assumption that a company's dividends will grow at a constant rate in perpetuity.

5 Must Know Facts For Your Next Test

1. The Gordon growth model is used to calculate the intrinsic value of a stock based on its expected future dividend payments.
2. The model assumes that a company's dividends will grow at a constant rate in perpetuity, which is known as the 'constant growth rate'.
3. The present value of the stock is calculated by dividing the expected next year's dividend by the difference between the required rate of return and the constant growth rate.
4. The required rate of return is the discount rate used to calculate the present value of the future dividend payments.
5. The Gordon growth model is particularly useful for valuing mature companies with stable dividend growth rates.

Review Questions

• Explain how the Gordon growth model is used to calculate the intrinsic value of a stock.
  • The Gordon growth model calculates the intrinsic value of a stock by estimating the present value of its future dividend payments. It assumes that a company's dividends will grow at a constant rate in perpetuity. The formula used in the model is: Intrinsic Value = D1 / (r - g), where D1 is the expected next year's dividend, r is the required rate of return, and g is the constant growth rate of the dividends. By inputting these values, the model can determine the intrinsic value of the stock.
• Describe the key assumptions underlying the Gordon growth model.
  • The Gordon growth model relies on several key assumptions: 1) The company will pay dividends indefinitely, 2) The dividends will grow at a constant rate in perpetuity, 3) The required rate of return is greater than the constant growth rate, and 4) The company has a stable, mature business model. These assumptions allow the model to simplify the valuation process by focusing on the expected future dividend payments and the constant growth rate, rather than trying to forecast the company's cash flows in detail.
• Analyze how changes in the required rate of return and the constant growth rate affect the intrinsic value of a stock calculated using the Gordon growth model.
  • In the Gordon growth model, the intrinsic value of a stock is inversely related to the required rate of return (r) and directly related to the constant growth rate (g). If the required rate of return increases, the intrinsic value will decrease, as the future dividends are discounted at a higher rate. Conversely, if the constant growth rate increases, the intrinsic value will rise, as the future dividends are expected to grow at a faster pace. The sensitivity of the intrinsic value to changes in these inputs highlights the importance of accurately estimating the required rate of return and the constant growth rate when using the Gordon growth model for stock valuation.

Related terms

Dividend Discount Model: A method of valuing a stock by discounting its expected future dividend payments back to their present value.

Constant Growth Rate: The rate at which a company's dividends are expected to grow indefinitely.

Discount Rate: The rate used to calculate the present value of future cash flows, reflecting the time value of money and the risk associated with the investment.