Question

What are two assumptions when one applies the constant growth model to analyze stock price?

Obs: Please be detailed.

Answer 1

Constant growth model or in other words Gordon's constant growth model is a kind of equity valuation model where the dividends are discounted at the cost of equity with the underlying assumption that the dividends grow at a constant rate. If D0 is the current dividend and g is the growth rate, then next years dividends, D1 = D0*(1+g) , for the second year it is D0*(1+g)^2 and like wise.

As the dividends are growing at a constant rate, the value of equity can be found by V0 = D1/(k-g) where K is the cost of equity.

There are some underlying assumptions in the constant growth model and they are

a) The model assumes that dividends are a suitable measure and parameter for valuation.

b) Dividends grow at a constant rate and do not have multiple growth rates.

c) It assumes that the cost of equity or the required rate of return on equity does not change and remains constant forever.

d) Also, as the denominator is such that the growth rate is reduced from the cost of equity, the model assumes that the cost of equity is always greater than the growth rate in dividends.