The Constant growth model is a financial valuation method that is used to estimate the intrinsic value of a stock. This model is also known as the Gordon Growth Model, after Myron Gordon, who developed the model in 1959. The constant growth model is based on the assumption that a company will continue to grow at a constant rate into the future, and that the rate of growth will be stable and predictable. The model is often used by investors to estimate the fair value of a stock, and to determine whether it is undervalued or overvalued in the market.
Assumptions of the Constant Growth Model:
The constant growth model is based on a few key assumptions about the company being valued. These assumptions include:
- The company’s dividends will continue to grow at a constant rate: The constant growth model assumes that the company will continue to pay dividends, and that these dividends will grow at a constant rate into the future.
- The growth rate of the dividends will be less than the required rate of return: The constant growth model assumes that the growth rate of the dividends will be less than the required rate of return, which is the minimum rate of return that investors require to invest in the stock.
- The growth rate will remain constant: The constant growth model assumes that the growth rate of the dividends will remain constant for an indefinite period of time.
Formula for the Constant Growth Model:
The formula for the constant growth model is as follows:
V = D / (r – g)
Where:
V = Intrinsic value of the stock
D = Annual dividend per share
r = Required rate of return
g = Constant growth rate of the dividends
The constant growth model assumes that the value of a stock is equal to the present value of its future dividends. The dividend is divided by the difference between the required rate of return and the growth rate of the dividends. This formula can be used to estimate the intrinsic value of a stock, which can then be compared to the market price of the stock to determine whether it is undervalued or overvalued.
Example of the Constant Growth Model:
Suppose a company pays an annual dividend of $2 per share, and the required rate of return for investors is 10%. The company is expected to grow at a constant rate of 5% per year. Using the constant growth model, the intrinsic value of the stock can be calculated as follows:
V = D / (r – g)
V = $2 / (0.10 – 0.05)
V = $40
This means that the intrinsic value of the stock is $40 per share. If the market price of the stock is less than $40 per share, then the stock may be considered undervalued and a good investment opportunity.
Limitations of the Constant Growth Model:
While the constant growth model is a useful tool for estimating the intrinsic value of a stock, it is not without its limitations. Some of the key limitations of the model include:
- The model assumes a constant growth rate: The constant growth model assumes that the growth rate of the dividends will remain constant for an indefinite period of time. However, this may not always be the case in practice.
- The model is sensitive to changes in the growth rate: The value of the stock is highly sensitive to changes in the growth rate of the dividends. Small changes in the growth rate can result in significant changes in the intrinsic value of the stock.
- The model is based on historical data: The constant growth model is based on historical data and assumes that past trends will continue into the future. However, this may not always be the case in practice.
- The model does not take into account non-dividend factors: The constant growth model only considers the growth rate of the dividends, and not for non-dividend factors.