Gordon growth model

Definition

The Gordon Growth Model (GGM) is a method used to determine the intrinsic value of a stock based on a series of future dividends that are expected to grow at a constant rate. It assumes that dividends will continue to increase at a stable growth rate indefinitely.

5 Must Know Facts For Your Next Test

1. The formula for GGM is P0 = D1 / (r - g), where P0 is the current stock price, D1 is the dividend next year, r is the required rate of return, and g is the growth rate.
2. GGM is primarily applicable to companies with stable dividend growth rates.
3. If the growth rate (g) exceeds the required rate of return (r), the model becomes invalid as it implies an infinite value.
4. GGM can be used to infer whether a stock is overvalued or undervalued based on its intrinsic value.
5. One limitation of GGM is that it doesn’t account for changes in dividend policies or external market conditions.

Review Questions

• What variables are needed to calculate the intrinsic value using the Gordon Growth Model?
• Why does the Gordon Growth Model become invalid if the growth rate exceeds the required rate of return?
• What type of companies are most suitable for valuation using GGM?

Related terms

Dividend Discount Model (DDM): A valuation method that calculates the present value of expected future dividends.

Intrinsic Value: The actual worth of a financial asset based on fundamental analysis without reference to its market value.

Required Rate of Return: The minimum annual percentage earned by an investment that will induce individuals or companies to put money into a particular security or project.