Stock Pricing Formula Explained Through Gordon Growth Model
The Gordon Growth Model (GGM) is a simple yet powerful formula used to estimate the intrinsic value of a company's stock. This model, named after American economist Myron J. Gordon, offers a straightforward approach to comparing companies of different sizes and industries.
The GGM formula is as follows:
[ \text{Intrinsic Value} = \frac{D_1}{r - g} ]
Where: - (D_1) represents the dividend expected next year (i.e., the current dividend (D_0) grown by one period: (D_1 = D_0 \times (1+g))) - (r) stands for the required rate of return (or discount rate) - (g) is the constant dividend growth rate
The GGM assumes that dividends grow at a constant rate indefinitely, making it most suitable for well-established companies with predictable dividend growth.
To use the GGM, you'll need three key inputs: - The current dividend per share ((D_0)) - The constant dividend growth rate ((g)) - The required rate of return ((r))
The model calculates the present value of an infinite series of dividends growing at a constant rate, providing the stock’s intrinsic value based on dividend forecasts.
It's essential to note that the GGM has its limitations. For instance, it ignores non-dividend factors that can add to a company's value, such as brand loyalty and customer retention. Also, the GGM can only be used to value stocks that issue dividends, excluding most growth stocks.
Moreover, if the required rate of return is the same as the growth rate, the value per share approaches infinity. On the other hand, if the required rate of return is less than the growth rate of dividends per share, the result is negative, rendering the model worthless.
When interpreting the GGM's results, if the intrinsic value is lower than the current trading price, the stock is seen as overvalued and should be considered a sell. Conversely, if the intrinsic value is higher than the stock's market price, the stock is considered undervalued and a potential buy.
In summary, the Gordon Growth Model offers a practical and easy-to-understand method for valuing dividend-paying stocks. However, it's crucial to remember that the GGM is just one of many tools investors can use to assess a company's worth, and it should be used in conjunction with other analysis methods.
[1] Investopedia. (2021). Gordon Growth Model. Investopedia. https://www.investopedia.com/terms/g/gordon_growth_model.asp [3] Investopedia. (2021). Dividend Discount Model. Investopedia. https://www.investopedia.com/terms/d/dividenddiscountmodel.asp
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- Smart investors routinely employ a variety of tools for valuing businesses, such as the Dividend Discount Model (DDM), which evaluates a stock by predicting its future dividends, or the GGM, which provides an intrinsic value based on dividend forecasts.
