Question

1. Compare and explain the follwoing two model

1. Constant Perpetual Growth Model
2. Two-Stage Dividend Growth Model:

Answer 1

CONSTANT GROWTH MODEL

The Gordon Growth Model (GGM) or Constant growth Model is used to determine the intrinsic value of a stock based on a future series of dividends that grow at a constant rate. It is a popular and straightforward variant of a dividend discount mode (DDM).

Given a dividend per share that is payable in one year and the assumption the dividend grows at a constant rate in perpetuity, the model solves for the present value of the infinite series of future dividends. Because the model assumes a constant growth rate, it is generally only used for companies with stable growth rates in dividends per share.

The Formula for the Constant Growth Model Is

P = D1/(r -g)

Where,

P = Current Stock Price

g = constant growth rate expected for dividend in perpetuity

r = cost of equity capital

D1 = value of nect years dividend

The Gordon Growth Model values a company's stock using an assumption of constant growth in payments a company makes to its common equity shareholders. The three key inputs in the model are dividends per share, the growth rate in dividends per share, and the required rate of return.

Dividends (D) per share represent the annual payments a company makes to its common equity shareholders, while the growth rate (g) in dividends per share is how much the rate of dividends per share increases from one year to another. The required rate of return (r) is a minimum rate of return investors are willing to accept when buying a company's stock, and there are multiple models investors use to estimate this rate.

The Gordon Growth Model assumes a company exists forever and pays dividends per share that increase at a constant rate. To estimate the value of a stock, the model takes the infinite series of dividends per share and discounts them back into the present using the required rate of return. The result is the simple formula above, which is based on the mathematical properties of an infinite series of numbers growing at a constant rate.

The GGM attempts to calculate the fair value of a stock irrespective of the prevailing market conditions and takes into consideration the dividend payout factors and the market expected returns. If the value obtained from the model is higher than the current trading price of shares, then the stock is considered to be undervalued and qualifies for a buy, and vice versa.

Example Using the Gordon Growth Model

As a hypothetical example, consider a company whose stock is trading at $110 per share. This company requires an 8% minimum rate of return (r) and currently pays a $3 dividend per share (D1), which is expected to increase by 5% annually (g).

The intrinsic value (P) of the stock is calculated as follows:

​P= $3/( 0.08-0.05 ) = $100

According to the Gordon Growth Model, the shares are currently $10 overvalued in the market.

Limitations of the Constant Growth Model

The main limitation of the Constant growth model lies in its assumption of a constant growth in dividends per share.2 It is very rare for companies to show constant growth in their dividends due to business cycles and unexpected financial difficulties or successes. The model is thus limited to firms showing stable growth rates.

The second issue occurs with the relationship between the discount factor and the growth rate used in the model. If the required rate of return is less than the growth rate of dividends per share, the result is a negative value, rendering the model worthless. Also, if the required rate of return is the same as the growth rate, the value per share approaches infinity.

TWO STAGED DIVIDEND GROWTH MODEL

The two-stage dividend discount model comprises two parts and assumes that dividends will go through two stages of growth. In the first stage, the dividend grows by a constant rate for a set amount of time. In the second, the dividend is assumed to grow at a different rate for the remainder of the company’s life. In this way, the second part of the two-stage model is basically identical to the Gordon Growth Model, so a firm grasp of the more basic formula will help you to better understand the two-stage model and other, more complex, formulas.

The two-stage model is often used to determine the intrinsic value of a stock issued by a company that is undergoing rapid expansion. Newer companies that have proven their staying power but are still in their initial stage of rapid growth are good candidates for this valuation method. The first stage of two-stage dividend growth is generally assumed to be quite aggressive, reflecting the company’s swift expansion, while the second stage assumes a lower, more sustainable rate of dividend growth.

Let us understand the two stages dividend growth model by following example :

Drawbacks of two staged growth model

While the two-stage dividend discount model can provide a more accurate valuation than simpler formulas, it does inherit some disadvantages from its single-rate predecessor, the Gordon Growth Model. Firstly, both models assume constant rates of growth, which is rarely an accurate representation of dividend growth. Though the two-stage model does account for multiple growth rates, it assumes that the switch happens over night, rather than accounting for a gradual decline between the first, more aggressive growth rate, and the stable growth rate in the second stage.

Another drawback shared by all dividend models is that they do not account for outside factors that influence stock prices, such as public sentiment or company innovations. These valuations are based solely on dividend payments and do not provide a comprehensive reflection of the true value of a stock.

Hope It Helps.