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Dividend Growth Model (Gordon Growth Model) of Share Valuation
The Dividend Discount Model or the Gordon Growth Model is a share valuation method that determines a stock’s intrinsic value. This method does not consider the current market conditions. Investors can compare companies against each other using this simple model. Dividend discount model is called "perpetual growth model" because the dividends are usually paid till infinity.
Assumptions for Gordon Growth Model
The Gordon Growth Model considers the following conditions −
The company has a stable business model, i.e., there are will be no significant changes in its operations in future.
The company will have a stable financial leverage.
The company’s growth is constant and unchanging.
The free cash flow obtained is paid as dividends.
Dividend Discount Model Formula
The Gordon Growth formula is given by,
$$\mathrm{IV =\frac{𝐷_{1}}{(𝑘 − 𝑔)}}$$
Where,
IV is Intrinsic Value,
𝑫𝟏 is the expected annual dividend per share dividend for the nextyear,
k is the required rate of return, and
g is the expected dividend growth rate.
Significance of the Gordon Growth Model
The Dividend Discount Model can be used to check the relationship between growth and discount rates, and the valuation of a share. Although there is a sensitivity of valuation with the shifts in the discount rate, the model is still able to demonstrate a subtle relation between valuation and return.
Drawbacks of the Gordon Growth Model
Following are the drawbacks of the Gordon Growth Model −
The Gordon Growth model considers that the company grows at a constant rate which is a major problem. It is highly unlikely that the increase of dividends occurs at a constant rate. The method is also highly sensitive to the discount factor used and the growth rate.
When the required rate of return is smaller than the actual growth rate, the Gordon Growth Model can result in a negative value. Also, the price per share tends to infinity if the required rate of return and growth rate are equal, which is conceptually misleading.
As the Dividend Discount Model does not take into consideration other market conditions such as non-dividend factors, stocks may be undervalued despite a company’s brand strength and steady growth.
Note − The Gordon Growth Model doesn’t take non-dividend factors into consideration.
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