Dividend growth model is a valuation model, that calculates the fair value of stock, assuming that the dividends grow either at a stable rate in perpetuity or at a different rate during the period at hand.
The dividend growth model determines if a stock is overvalued or undervalued assuming that the firm’s expected dividends grow at a value g forever, which is subtracted from the required rate of return (RRR) or k.
The Gordon growth model (GGM) is used to determine the intrinsic value of a stock based on a future series of dividends that grow at a constant rate. It is a popular and straightforward variant of the dividend discount model (DDM). The GGM assumes that dividends grow at a constant rate in perpetuity and solves for the present value of the infinite series of future dividends.
Because the model assumes a constant growth rate, it is generally only used for companies with stable growth rates in dividends per share.
Therefore, the stable dividend growth model formula calculates the fair value of the stock as P = D1 / ( k – g ). The multistage stable dividend growth model equation assumes that g is not stable in perpetuity, but, after a certain point, the dividends are growing at a constant rate.
For a company paying out a steadily rising dividend, one can estimate the fair value of the stock with a formula that considers that constantly increasing payout is responsible for the stock’s value. The formula is,
P = D / (r−g)
P is the current share price
D is the next dividend the company has to pay
g is the expected growth rate in the dividend
r is the required rate of return for the company
The Gordon Growth Model (GGM), named after economist Myron J. Gordon, calculates the fair value of a stock by examining the relationship between three variables.
Dividends Per Share (DPS): DPS is the value of each declared dividend issued to shareholders for each common share outstanding and represents how much money shareholders should expect to receive on a per-share basis.
Dividend Growth Rate (g): The dividend growth rate is the projected rate of annual growth, which in the case of a single-stage GGM, a constant growth rate is assumed.
Required Rate of Return (r): The required rate of return is the “hurdle rate” needed by equity shareholders to invest in the company’s shares with consideration towards other opportunities with similar risks in the stock market.
Limitations of the Gordon Growth Model
The assumption that a company grows at a constant rate is a major problem with the Gordon Growth Model. In reality, it is highly unlikely that companies will have their dividends increase at a constant rate. Another issue is the high sensitivity of the model to the growth rate and discount factor used.
The model can result in a negative value if the required rate of return is smaller than the growth rate. Moreover, the value per share approaches infinity if the required rate of return and growth rate have the same value, which is conceptually unsound.
Furthermore, since the model excludes other market conditions such as non-dividend factors, stocks are likely to be undervalued despite a company’s brand and steady growth.