Question

Hi, how could the constant growth model be modified to become more useful?

Answer 1

• Information about CONSTANT GROWTH MODEL(DIVIDEND DISCOUNT MODEL)

One of the widely used models for fundamental analysis is the dividend discount
model (DDM), which allows investors to calculate the fair value of a share of stock
based on estimated dividends of the share, exclusive of other variables. The model is
originated in the 1960s by Myron J. Gordon, so the constant growth version of DDM
is called the Gordon Model as shown in the equation (1) below.
Vt = D,t+1/ (k - g) (1)
where:
Vt = fair value of a share at time t
D,t+1 = expected dividend per share at the end of period t+1
g = expected dividend growth rate of the share (assumed to be constant)
k = investor’s required rate of return of the share using Capital Asset Pricing Model
defned in the equation (2) below.
k = rf + beta*[E(r,m) – rf] (2)
where:
rf = risk-free rate which is the 10-year Treasury rate as of the evaluation date
beta = the systematic risk of the share
[E(r,m) – rf] = expected market rate of return minus risk-free rate
= the market risk premium (Mkt-Prem), which is generally 3~7% according
to Dimson/Marsh/Staunton (2003).

• MODIFIED CONSTANT GROWTH MODEL

Two key assumptions of the Gordon Model is that dividends are growing at a
constant rate and k > g. However, realistically speaking, dividends are not always
expected to grow at a constant rate. Therefore, the analyst has to treat dividends for the
non-constant stage separately from the constant stage, applying each year’s dividend
growth rate. Another problem is that if the company’s growth rate exceeds the required
rate of return, one cannot use the Gordon Model simply because the stocks don’t have
a negative value.
Alternatively, to avoid the problem of the high-growth cases, the Vt can be
calculated by the product of P/E and EPS as follows:
Vt = P/E * EPSt (3)
where:
P/E = price per share divided by earnings per share for a 12-month period
EPSt = earnings per share at period t (12-month period)
This writting adopts the alternative use of the above equation (3) to modify the DDM.

the modifed DDM suggested in this writting makes
it possible for an investor to investment decisions even if a key pre-condition of the constant dividend
growth model (k>g) is not met. Therefore, the modifcation suggests a practical
resolution of the dilemma in cases where k (the required rate of return) is not greater
than g (the dividend growth rate), which is the case for most high-growth stocks, in
attempts to use the constant dividend growth model for investment decisions. The
modifcation is based on utilization of the P/E multiple ratio of a stock instead of the
constant dividend model. In rare cases where the P/E ratio can have a negative value,
the modifcation cannot be used, which is beyond the scope . However,
since most P/E ratios are positive, the modifcation is quite practical.

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From Mona.....