Definition
The Gordon Growth Model (GGM) is a financial formula used to estimate the intrinsic value of a stock by calculating the present value of a future series of dividends that are assumed to grow at a constant rate indefinitely. Typically applicable to companies with stable dividend growth, the GGM provides investors with a straightforward method to understand whether a stock is under or overvalued.
GGM vs DDM Comparison
| Feature | Gordon Growth Model (GGM) | Dividend Discount Model (DDM) |
|---|---|---|
| Growth assumption | Constant growth rate | Various growth rates possible |
| Usage type | Best for stable companies | Used for a wider range of companies |
| Formula complexity | Relatively simple | Can be complex with variable growth |
| Dividend prediction | Assumes dividends grow forever | Predicts dividends over a specific timeframe |
Formula
The formula for the Gordon Growth Model is as follows:
\[ V = \frac{D_0 \times (1 + g)}{r - g} \]
- \(V\) = Intrinsic value of the stock
- \(D_0\) = Annual dividend payment of the current year
- \(g\) = Growth rate of dividends (in perpetuity)
- \(r\) = Required rate of return
Example
Suppose a company pays a current dividend \(D_0\) of $2.00, has a dividend growth rate \(g\) of 5%, and we require a return \(r\) of 10%. Plugging into the formula, we find:
\[ V = \frac{2.00 \times (1 + 0.05)}{0.10 - 0.05} = \frac{2.00 \times 1.05}{0.05} = \frac{2.10}{0.05} = 42.00 \]
Thus, the intrinsic value of the stock using the GGM is $42.00.
Related Terms
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Dividend Discount Model (DDM): A method for valuing a stock by discounting the expected future dividends to their present value.
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Present Value (PV): It calculates what a future sum of money is worth today based on a specified rate of return.
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Intrinsic Value: The actual value of a company or an asset based on fundamental analysis without reference to its market value.
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Capital Asset Pricing Model (CAPM): A model that establishes a theoretical expected return on an asset based on its systematic risk.
Fun Facts & Humour
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Did you know that if dividends could sing, they’d probably be singing “Endless Love”? Because in the GGM world, they grow forever! 🎤🎵
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“Investing is like a music concert; you keep your ears open for those harmonious dividends hitting the right notes!” 🎶
Frequently Asked Questions
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Why is the GGM only suitable for stable companies?
- It assumes a constant growth rate in dividends, which is typically only realistic for mature companies with predictable growth patterns.
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Can the GGM be used for companies that do not pay dividends?
- No, the GGM specifically requires a history of dividends to estimate the stock’s value.
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What happens if the growth rate equals the required rate of return?
- In this situation, the model breaks down as it would lead to a division by zero, signaling that the scenario is impractical or non-sustainable.
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How does the GGM handle fluctuating dividends?
- It struggles! Fluctuating dividends don’t fit the constant growth assumption. For those, you might need a more complex model like a multi-stage DDM.
Suggested Resources
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Books:
- “The Intelligent Investor” by Benjamin Graham
- “Valuation: Measuring and Managing the Value of Companies” by McKinsey & Company Inc.
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Online Resources:
Test Your Knowledge: Gordon Growth Model Quiz Time!
Thank you for diving into the Gordon Growth Model with me! Remember, steady dividends are like a good cup of coffee—they keep you alert for whatever the market throws your way! Stay informed and happy investing! ☕💰✨
