Every individual wishes to know the intrinsic value of the stock they intend to buy. The intrinsic value of stock gets us the true value of the stock. So, whether you are an investor or a trader, stock valuation is something that shouldn’t be ignored at any cost. Stock valuation is a method of finding the true value of a stock.
Once we have found out the intrinsic value of a stock, we would know whether it is undervalued or overvalued at its current market price. This helps us take an informed decision.
There are multiple methods that can help us get the intrinsic value of a stock. The method we cover here is – Gordon Dividend Growth Model.
It was named after Myron J. Gordon who along with Eli Shapiro published it in 1956.
Gordon Dividend Growth Model
When it comes to dividends for common stocks, no one can predict what their growth pattern could turn out to be. Some Corporations may hand out dividends regularly while some may entirely choose not to.
To find a stock valuation, Gordon’s Dividend Growth Model assumes that dividends would be paid at regular intervals and grow at a constant rate as well.
To forecast future dividends, we can use the following equation –
Dt = Dt-1(1+g)t
where Dt is the expected dividend at time t and
g is the expected dividend growth rate.
For instance, if $10 was paid out as a dividend recently and is expected to increase at a growth rate of 5% then, at the end of 9 years the total dividend paid comes out to be –
D10 = 10(1+.05)9 = $15.51
This leads us to the Gordon Dividend Growth Model equation –
P = D1/(r-g)
here, P is the current price of the stock.
D1 is the expected dividend one year from now. Here, don’t use the most-recent dividend paid or D0. Continuing with the above example where a $10 dividend was paid and it is expected to grow at 5%. In that case, D1 would turn out to be $10.5
r is the required return on our investment.
g is the expected constant dividend growth rate.
It is worth mentioning here that, the required return on our investment should be greater than the expected constant dividend growth rate.
When it comes to valuing stocks whose dividends aren’t expected to grow at all i.e. g = 0. In such case, the D1 is to be divided by r (or, the required return on our investment).
At this stage, one may ask about the required return on our investment, r. And, how to pick stocks with different earnings growth rates for the longer term? The Gordon Dividend Growth Model should be used for companies that are expected to grow at less than or equal to an economy’s nominal growth rate. And, the reason why we state this? It is tough for companies to grow at a faster rate than that an economy’s nominal growth rate. They would eventually face a slowdown.
With the help of the Gordon Dividend Discount Model, one can arrive at the fair value or price of a stock in consideration. That would help us know whether the stock is available at a premium or discount.
Limitations with Gordon Dividend Discount Model
The dividend is the amount paid by a Corporation to its stockholders out of its profits. But, vagaries in the Business cycle would impact the profitability of a Corporation. It is not possible to pay dividends at a constant growth rate. During the Business cycle phases, stockholders may receive higher dividends in one phase while nothing at all in another phase. So, not all companies qualify to be analyzed with the model.
Apart from that, if the required rate of return is less than the expected constant dividend growth rate then the value in the denominator gets into negative territory. Or, if both the rates are the same then the model can’t be applied.
Conclusion
The model is based entirely on the expected dividend growth rate to arrive at the fair price of a stock. Though there are other factors as well that come to play. Through Gordon Dividend Discount Model, one doesn’t have to take the market and economic conditions into consideration.