A Gordon Growth (Constant Growth) Model
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The Gordon Growth Model (or Constant Growth Model) is a financial model used to determine the “intrinsic” value of a stock, based on future dividends, which are assumed to grow at a constant rate. Named after Myron J. Gordon and originally published in 1959, the model values a business as the present value of all future dividends and leverages a required rate of return that the investor could receive on similar alternative assets.
Arriving at Present Value
The Gordon Growth Model is the best known of a class of discounted dividend models and is a variation of the discounted cash flow valuation model. The Gordon approach assumes that the company pays a dividend that grows at a constant rate. It also assumes that the investor’s required rate of return for the stock is held constant and is equal to the cost of equity for that company. The model sums this discounted, infinite series of payments to the shareholder to arrive at the present value.
A Stock as a Perpetuity
Note that if the stock is never sold, then it is essentially a perpetuity to the investor and its price would equal the sum of the present value of its dividends. Because the model considers the current price of the stock to be equal to its future cash flows, then it follows that the future sale price of the stock would equal the sum of the cash flows subsequent to the sale discounted by the required rate of return.
Under the Gordon Model the investor holds the stock for the sole purpose of receiving income from company operations through dividend payments. Investors (like Warren Buffet) who look at stocks as if they were buying a private business may benefit from this valuation approach.
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Downside to the Gordon Growth Model
While the Gordon Growth Model assumes that the earnings growth is constant for perpetuity, in practice this would be difficult for a company to achieve. Most analysts assume that a high growth rate can be sustained for only a limited number of years, followed by a sustainable rate of growth. The discounted cash flow model accounts for this by assigning a terminal growth rate.
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The above information is educational and should not be interpreted as financial advice. For advice that is specific to your circumstances, you should consult a financial or tax advisor.
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