Question

Discuss the how we can use the Dividend (Gordon) Growth model to indicate the intrinsic value of company shares. Be sure to provide as part of this discussion certain assumptions we can make regarding growth and the required rate of return to be used in this analysis and limitations of utilizing this model for valuation purposes.

Answer 1

Dividend Gordon Model is one of the very well known methods of valuing a Company stock based on the dividends paid by the company in the future years that grow at a constant rate. It is a variant of the Dividend Discount Model.

Formula for Intrinsic Value of a share: D1/ (Re-g)

where, D1= dividend of next year (incorporating growth )

Re= required return on the stock (or cost of equity)

g= constant growth rate over the years

Assumptions:

1. the Model assumes that the dividend will grow at the constant growth rate till perpetuity.

2. The company has stable financial leverage

3. The company will surely pay dividends from its surplus profits in the future years

4. The model of business of the company is expected to remain stable in the coming years

5. The required rate of return will be greater than the growth rate in the future years till maturity. Otherwise the value will not be dependable.

Limitations of using this model for Valuation:

1. It is unlikely that a Company will maintain a constant growth rate for its dividend over the future years owing to business uncertainties.

2. If the required rate of return is less than the growth rate of future dividends, then as per the valuation formula, we will get a negative value of the share. This situation will make the model worthless. Even if the required return and growth rate are equal, still it wont be feasible to depend on this model as it will generate an infinite value of the share.