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The Constant Growth Model of Share Valuation
The Constant Growth Model is a way of share evaluation. Also known as Gordon Growth Model, it assumes that the dividends paid by the company will continue to go up at a constant growth rate indefinitely. It helps investors determine the fair price to pay for a stock today based on future dividend payments.
For a company paying out a steadily rising dividend, one can estimate the fair value of the stock with a formula that considers that constantly increasing payout is responsible for the stock's value. The formula is,
$$\mathrm{𝑃 =\frac{𝐷}{(𝑟 − 𝑔)}}$$
Where,
P is the current share price,
D is the next dividend the company has to pay,
g is the expected growth rate in the dividend, and
r is the required rate of return for the company.
The Required Rate of Return (RRR) is the minimum due on the investment that investors will accept to keep the stock. Although the formula for calculating the growth is easy, there are some cautions that need to be taken care of while using the Gordon Growth Model.
Estimation Errors
Attention must be paid to estimate the errors while calculating the value of the share in the Gordon Growth Model. While considering the value, many shares must be considered instead of just one share. This process reduces the value of errors occurring during the estimation of the stock’s fair value.
High Current Growth Rate
The formula for estimating the share’s fair value should not be applied to a company that has a very high growth rate. The constant growth formula assumes that the growth is sustainable till infinity. So, assuming too high growth rates may lead to evaluation with erroneous outcomes.
If Gordon Growth Models is applied to a share that is overestimated, the slowing growth rates are missed after a certain period when the growth rate matures and takes a constant shape.
Errors in Forecasting Dividends
In some cases, the market estimates for the fair value of a stock may not match the estimates counted using the Gordon Growth Model formula. This does not mean the formula is incorrect. In fact, it means that the dividend stream has not been forecasted correctly.
Note − To get a correct fair value of a stock, the errors in estimation must be removed first.
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