The Gordon Growth Model (GGM) is a variation of the standard discount model. The key difference is that the GGM model assumes the dividends will grow at a constant rate till perpetuity.
If the current year’s dividends are D0, and the dividend growth rate is gc, the next year’s dividend D1 will be D0 = (1+gc). D2 will be D0(1+gc)^2 and so on.
With this assumption, the value of the stock can be calculated using the following simplified formula:
The model has several assumptions:
- It assumes that the dividends are a suitable measure for valuation.
- It assumes that both the required return on equity and dividend growth rate will be constant forever.
- The required return on common equity must be greater than the expected growth rate of the dividend.
Let’s calculate the value of a stock that paid a dividend of $5 last year. The required return on equity is 10% and the dividend is expected to grow by 5%.
Using the GGM model, the value of the stock will be:
V = $5(1.05)/(10% – 5%) = $105
As you can notice, the value of the stock is sensitive to the denominator and therefore to the dividend growth rate. You can also determine how much of the stock value is attributed to the dividend growth rate. This can be done by recalculating the value with zero growth rate and then noting the difference.
With a zero growth rate, the stock value will be = $5/10% = $50. So, we can say that out of $105, $55 ($105 – $50) is attributed to the dividend growth rate.
The GGM is suitable in the following cases:
- The analyst is looking at broad equity indexes.
- The analyst is valuing steadily growing companies that pay dividends.
- Highly sensitive to small changes in required return on equity and dividend growth rate.
- The model cannot be used to value companies that do not pay dividends.
- The model cannot be used to value companies that don’t have a stable growth rate.