The Gordon’s Model, given by Myron Gordon, also supports the doctrine that dividends are relevant to the share prices of a firm. Here the Dividend Capitalization Model is used to study the effects of dividend policy on a stock price of the firm.
Gordon’s Model assumes that the investors are risk averse i.e. not willing to take risks and prefers certain returns to uncertain returns. Therefore, they put a premium on a certain return and a discount on the uncertain returns. The investors prefer current dividends to avoid risk; here the risk is the possibility of not getting the returns from the investments.
But in case, the company retains the earnings; then the investors can expect a dividend in future. But the future dividends are uncertain with respect to the amount as well as the time, i.e. how much and when the dividends will be received. Thus, an investor would discount the future dividends, i.e. puts less importance on it as compared to the current dividends.
According to the Gordon’s Model, the market value of the share is equal to the present value of future dividends. It is represented as:
P = [E (1-b)] / Ke-br
Where, P = price of a share
E = Earnings per share
b = retention ratio
1-b = proportion of earnings distributed as dividends
Ke = capitalization rate
Br = growth rate
Assumptions of Gordon’s Model
- The firm is an all-equity firm; only the retained earnings are used to finance the investments, no external source of financing is used.
- The rate of return (r) and cost of capital (K) are constant.
- The life of a firm is indefinite.
- Retention ratio once decided remains constant.
- Growth rate is constant (g = br)
- Cost of Capital is greater than br
- K > br = g if this condition is not fulfilled, we cannot get a meaningful value for the share.
Criticism of Gordon’s Model
- It is assumed that firm’s investment opportunities are financed only through the retained earnings and no external financing viz. Debt or equity is raised. Thus, the investment policy or the dividend policy or both can be sub-optimal.
- The Gordon’s Model is only applicable to all equity firms. It is assumed that the rate of returns is constant, but, however, it decreases with more and more investments.
- It is assumed that the cost of capital (K) remains constant but, however, it is not realistic in the real life situations, as it ignores the business risk, which has a direct impact on the firm’s value.
Thus, Gordon model posits that the dividend plays an important role in determining the share price of the firm.