The Gordon growth model is used to determine the intrinsic value of a stock based on a future series of dividends that grow at a constant rate. Given a dividend per share that is payable in one year, and the assumption the dividend grows at a constant rate in perpetuity, the model solves for the present value of the infinite series of future dividends.
The Gordon growth model values a company’s stock using an assumption of constant growth in payments a company makes to its common equity shareholders. The three key inputs in the model are dividends per share, growth rate in dividends per share and required rate of return. Dividends per share represent the annual payments a company makes to its common equity shareholders, while the growth rate in dividends per share is how much dividends per share increases from one year to another. The required rate of return is a minimum rate of return investors are willing to accept when buying a stock of a particular company, and there are multiple models investors use to estimate this rate.
The Gordon growth model assumes a company exists forever and pays dividends per share that increase at a constant rate. To estimate the value of a stock, the model takes the infinite series of dividends per share and discounts them back into the present using the required rate of return. The result is a simple formula, which is based on mathematical properties of an infinite series of numbers growing at a constant rate.
Limitations of the Gordon Growth Model-
The main limitation of the Gordon growth model lies in its assumption of a constant growth in dividends per share. It is very rare for companies to show constant growth in their dividends due to business cycles and unexpected financial difficulties or successes. Therefore, the model is limited to firms showing stable growth rates. The second issue has to do with the relationship between the discount factor and the growth rate used in the model. If the required rate of return is less than the growth rate of dividends per share, the result is a negative value, rendering the model worthless. Also, if the required rate of return is the same as the growth rate, the value per share approaches infinity.
According to the Walter’s Model, given by prof. James E. Walter, the dividends are relevant and have a bearing on the firm’s share prices. Also, the investment policy cannot be separated from the dividend policy since both are interlinked.
Walter’s Model shows the clear relationship between the return on investments or internal rate of return (r) and the cost of capital (K). The choice of an appropriate dividend policy affects the overall value of the firm. The efficiency of dividend policy can be shown through a relationship between returns and the cost.
- If r>K, the firm should retain the earnings because it possesses better investment opportunities and can gain more than what the shareholder can by re-investing. The firms with more returns than a cost are called the “Growth firms” and have a zero payout ratio.
- If r<K, the firm should pay all its earnings to the shareholders in the form of dividends, because they have better investment opportunities than a firm. Here the payout ratio is 100%.
- If r=K, the firm’s dividend policy has no effect on the firm’s value. Here the firm is indifferent towards how much is to be retained and how much is to be distributed among the shareholders. The payout ratio can vary from zero to 100%.
Assumptions of Walter’s Model-
- All the financing is done through the retained earnings; no external financing is used.
- The rate of return (r) and the cost of capital (K) remain constant irrespective of any changes in the investments.
- All the earnings are either retained or distributed completely among the shareholders.
- The earnings per share (EPS) and Dividend per share (DPS) remains constant.
- The firm has a perpetual life.
According to Miller and Modigliani Hypothesis or MM Approach, dividend policy has no effect on the price of the shares of the firm and believes that it is the investment policy that increases the firm’s share value.
The investors are satisfied with the firm’s retained earnings as long as the returns are more than the equity capitalization rate “Ke”. What is an equity capitalization rate? The rate at which the earnings, dividends or cash flows are converted into equity or value of the firm. If the returns are less than “Ke” then, the shareholders would like to receive the earnings in the form of dividends.
Assumptions of Miller and Modigliani Hypothesis-
- There is a perfect capital market, i.e. investors are rational and have access to all the information free of cost. There are no floatation or transaction costs, no investor is large enough to influence the market price, and the securities are infinitely divisible.
- There are no taxes. Both the dividends and the capital gains are taxed at the similar rate.
- It is assumed that a company follows a constant investment policy. This implies that there is no change in the business risk position and the rate of return on the investments in new projects.
- There is no uncertainty about the future profits, all the investors are certain about the future investments, dividends and the profits of the firm, as there is no risk involved.
A model theorizing how a publicly-traded company sets its dividend policy. The model states that dividends are paid according to two factors. The first is the net present value of earnings, with higher values indicating higher dividends. The second is the sustainability of earnings; that is, a company may increase its earnings without increasing its dividend payouts until managers are convinced that it will continue to maintain such earnings.
The Lintner’s Model was useful in assessing the structure of our dividend payment policy to ensure investors were optimally compensated.