The Gordon Growth Model (GGM), also known as the Dividend Discount Model (DDM), is a valuation method used to estimate the intrinsic value of a stock based on its future dividends. It assumes that dividends will grow at a constant rate indefinitely.
Formula:
P0=D1r−gP_0 = \frac{D_1}{r – g}
Where:
- P0P_0: Current stock price
- D1D_1: Expected dividend in the next period (Year 1 dividend)
- rr: Required rate of return (or discount rate)
- gg: Dividend growth rate
Assumptions:
- Dividends grow at a constant rate (gg) forever.
- The required rate of return (rr) is greater than the growth rate (r>gr > g).
- The company pays regular dividends.
Example:
Suppose:
- The expected dividend next year (D1D_1) = $2.00
- The required rate of return (rr) = 10% or 0.10
- The dividend growth rate (gg) = 4% or 0.04
Using the GGM formula: P0=2.000.10−0.04=2.000.06=33.33P_0 = \frac{2.00}{0.10 – 0.04} = \frac{2.00}{0.06} = 33.33
Thus, the intrinsic value of the stock is $33.33.
Strengths:
- Simplicity: Easy to use and apply for companies with stable and predictable dividend growth.
- Focus on dividends: Emphasizes the importance of dividend payouts in valuation.
Limitations:
- Constant Growth Assumption: The model fails for companies with irregular or unpredictable dividend growth.
- Non-dividend-paying stocks: It cannot be used for companies that do not pay dividends.
- Sensitive to inputs: Small changes in rr or gg can result in significant valuation changes.
Variants:
- Zero Growth Model: Assumes dividends do not grow (g=0g = 0). The formula becomes: P0=DrP_0 = \frac{D}{r}
- Two-stage or Multi-stage Growth Models: Used when dividends are expected to grow at varying rates over time before settling into a constant growth phase.
