Question

How is the constant growth dividend model, also known as the “Gordon Model,” useful for estimating the price of equity or determining the cost of equity. When is the model appropriate to use? This model is used frequently by financial analysts, even though no firm has perfectly constant growth. Why do you think this is? Discuss two ways in which the growth rate may be determined. How might one gauge the stability of a growth rate determined using these methods? (please provide an essay / paragraph length answer, 200-300 words)

Answer 1

The Gordon 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 the popular and straightforward variant of a dividend discount mode.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.

As  this model assumes a constant growth rate,it is generally only used for companies with stable growth rates in dividends per share.The dividend payout of the firm has to be consider with the assumption of stability,since stable firms generally pay substantial dividendsIn particular,this model will under estimate the value of the stock in firms that consistently pay out less they can afford and accumulate cash in the process.

This method is not used by firms that did not have constant growth.

The formula for the Gordon Growth Model is

  

The two ways in which the growth rate may be determined:

First, since the growth rate in the firm's dividends is expected to last forever, the firm's other measures of performance (including earnings) can also be expected to grow at the same rate. To see why, consider theconsequences in the long term of a firm whose earnings grow 6% a year forever, while itsdividends grow at 8%. Over time, the dividends will exceed earnings. On the other hand, if afirm's earnings grow at a faster rate than dividends in the long term, the payout ratio, in thelong term, will converge towards zero, which is also not a steady state. Thus, though thmodel's requirement is for the expected growth rate in dividends, analysts should be able tosubstitute in the expected growth rate in earnings and get precisely the same result, if thefirm is truly in steady state.The second issue relates to what growth rate is reasonable as a 'stable' growth rate.As noted in Chapter 12, this growth rate has to be less than or equal to the growth rate of theeconomy in which the firm operates. This does not, however, imply that analysts will always agree about what this rate should be even if they agree that a firm is a stable growth firm for three reasons.

• Given the uncertainty associated with estimates of expected inflation and real growthin the economy, there can be differences in the benchmark growth rate used bydifferent analysts, i.e., analysts with higher expectations of inflation in the long termmay project a nominal growth rate in the economy that is higher.

• The growth rate of a company may not be greater than that of the economy but it canbe less. Firms can becomes smaller over time relative to the economy.

• There is another instance in which an analyst may be stray from a strict limit imposed on the 'stable growth rate'. If a firm is likely to maintain a few years of'above-stable' growth rates, an approximate value for the firm can be obtained byadding a premium to the stable growth rate, to reflect the above-average growth inthe initial years. Even in this case, the flexibility that the analyst has is limited. Thesensitivity of the model to growth implies that the stable growth rate cannot be morethan 1% or 2% above the growth rate in the economy. If the deviation becomeslarger, the analyst will be better served using a two-stage or a three-stage model tocapture the 'super-normal' or 'above-average' growth and restricting the Gordon bgrowth model to when the firm becomes truly stable.