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

The dividend (Gordon) growth model computes and determines the intrinsic value of a stock on the basis of its future dividends that the stock will pay.

The formula for Gordon growth model is:

Intrinsic value of a stock = D1/(r-g)

Where, D1 is the value of next year’s dividend, r is the cost of equity capital (or the rate of return) and g is the growth rate for dividends.

The assumptions that are made in case of Gordon growth model are:

• Growth rate (g) remains constant with regards to dividends
• Cost of equity capital or rate of return (r ) remains constant
• Dividends will go on till perpetuity

The limitation of using this model for valuation purpose is that this model does not take into account the prevailing market conditions. Secondly the assumption that growth rate will be constant with regards to a company’s dividend payments is a faulty assumption and in the real world this assumption does not hold ground. Lastly a limitation is there with regards to relationship between the discount factor and the growth rate used in the model. We can see in the formula that the denominator is r-g and so if g>r then the denominator becomes negative and this will make the model not capable of determining a value for the stock.