Constant Growth Model, also known as the Gordon Growth Model or the Dividend Discount Model (DDM), is a method used to estimate the value of a stock or company based on the theory that a stock is worth the present value of all its future dividends. This model is particularly useful for companies that pay dividends and are expected to continue growing those dividends at a steady rate indefinitely. It’s a straightforward and widely-used tool for equity valuation in finance.
Features of the Constant Growth Model:
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Dividend Growth Assumption
The model assumes that dividends will continue to grow at a constant rate (g) indefinitely. This growth rate is expected to be less than the discount rate.
- Formula
The value of the stock (P) is calculated using the formula:
- Simplicity
One of the model’s strengths is its simplicity, as it requires only three inputs: the current dividend, the required rate of return, and the growth rate of the dividends.
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Long-term Perspective
It is best suited for companies with stable growth rates and relatively predictable financial performance over the long term.
Applications:
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Valuation of Mature Companies
Model is most appropriate for mature companies in stable industries that pay regular dividends and have a history of steady growth rates.
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Financial Analysis and Stock Selection
Investors use it to determine whether a stock is overvalued or undervalued based on its current price compared to the calculated intrinsic value.
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Corporate Finance Decisions
Managers and analysts use the model for making decisions about financial policy, dividend policy, and business valuations.
Limitations:
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Sensitive to Growth Rate Changes
Model is highly sensitive to the estimated growth rate. Small changes in the growth assumption can result in large changes in the stock valuation.
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Not Suitable for Non-Dividend Paying Companies
It cannot be used to value companies that do not pay dividends or those that have unpredictable dividend policies.
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Assumption of Perpetual Growth
The assumption of perpetual growth at a constant rate is unrealistic for many companies, especially in rapidly changing industries or competitive environments.
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Risk Consideration
Model does not explicitly consider changes in risk profiles or the capital structure of the company, which can affect the required rate of return.