Gordon Growth Model
Definition of Gordon Growth Model
Gordon Growth Model is a model to determine the fundamental value of stock, based on the future sequence of dividends that mature at a constant rate, provided that the dividend per share is payable in a year, the assumption of the growth of dividend at a constant rate is eternity, the model helps in solving the present value of the infinite series of all future dividends. Since the assumption is based on the constant growth rate of dividends, this formula would be applicable mostly to well established and mature companies. This model was developed by Professor Myron Gordon, hence called Gordon Growth Model.
Formula for Gordon Growth Model
The formula used to find out the stock value using Gordon Growth Model is as follows
Stock Value (P) = D / (k – G)
D= Expected dividend per share one year from now
k= required rate of return for equity investor
G= Growth rate in dividends.
Advantages of Gordon Growth Model
The advantages of Gordon Growth Model are:
- The Gordon Growth Model is especially useful for companies that have a great cash inflow and the company has stability with dependable leverage patterns.
- The valuation can be easily performed since the inputs of data for Gordon’s Growth model are readily available for computation.
- The Gordon Growth model has been proven to be favorable to real estate agents and several real estate ventures too.
Disadvantages of Gordon Growth Model
The disadvantages of Gordon Growth model are:
- The Gordon Growth Model’s simple calculations can prove to be the major disadvantage as the model takes into consideration the quantitative figures and not the qualitative ones.
- The future changes cannot be taken into consideration which is why this model is not much preferred.
- The calculations are basically on future assumptions, which can be subjected to market changes based on the economic conditions and various other factors which contribute to being one of the major disadvantage.
- The limitations to the model make it less favorable for market and companies which has rapid changing dividend patterns.
This is why in spite of definite success with the companies that have a high cash flow in the company this model is not suitable for many other companies which are fast growing since it is not flexible enough to include the possible fluctuations in the dividend rates in the future. This model is especially not suited for companies that are in segregation but for companies that have a heavy cash in flow and out flow ratio.
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