Introduction
Gordon Growth Model is an important concept in finance, particularly in stock valuation of dividend-paying stocks. The model was developed by Myron J. Gordon, an economics professor at the University of Toronto, in 1959 and was a major contribution to the literature of valuation. It is a simple mathematical formula that provides an estimate of a companys stock value based on its dividends and the rate of return that investors would get if they held the stock for a certain period of time.
The main purpose of the Gordon Growth Model is to determine how much a stock should be worth now based on the trend of its dividends, which can be seen as an estimate of future cash flows. It assumes that a stocks dividend will grow at a certain steady rate over time, so a companys current stock price can be determined by predicting future dividends and discounting them back to the present day.
The formula of the Gordon Growth Model can be written as:
V=D1 / (rd – g)
Where:
V= the current stock price
D1= the current dividend
r= the required rate of return
d= the discount rate
g= the growth rate of dividends
In the equation, the required rate of return (r) compensates investors for the risk they take by investing in the stock. The growth rate of dividends (g) represents the company’s future dividends growth. The discount rate (d) represents the cost of delaying the receipt of the future cash flows which is equal to the required rate of return minus the growth rate of dividends.
To calculate the stock price using this model, there are three steps involved:
First Step: Estimate the future dividend of the company:
The dividend grows at a constant rate as assumed in the Gordon Growth Model, so the future dividend can be estimated by taking the current dividend and projecting it into the future. This is done by multiplying the current dividend by the yearly growth rate. The formula can be written as:
Dt = D1(1+g)^t
Where Dt is the estimated future dividend and t is the number of years into the future.
Second Step: Calculate the difference between the required rate of return and the growth rate of dividend:
The discount rate used in the Gordon Growth Model formula is derived from two values: the required rate of return and the growth rate of dividend. The discount rate is equal to the difference between these two values. The formula can be written as:
d = r – g
Third Step: Apply the Gordon Growth Model equation to calculate the stock price:
The estimated future dividend and the discount rate can be used to calculate the current stock price by plugging the values into the Gordon Growth Model equation. The formula can be written as:
V=D1 / (rd – g)
Conclusion
The Gordon Growth Model is an important concept in finance and a useful tool for stock valuation. It provides a way to estimate the current stock price based on its future dividends, the required rate of return, and the growth rate of dividends. The model is widely used and provides an effective means of stock valuation.
