Definition: The Gordon Growth Model (GGM) is a valuation model that values a stock by discounting the dividends that are distributed to a firm’s shareholders.
What Does Gordon Growth Model Mean?
What is the definition of Gordon Growth Model? Also known as Gordon Dividend Model, the Gordon Growth Model assumes that a firm is expected to achieve a steady growth, will maintain a stable financial leverage, and will pay out its free cash flows to its shareholders in the form of dividends . This model assumes that the dividend per share grows at a constant rate in perpetuity and therefore, the present value of a firm is calculated based on this assumption.
To calculate the fair value of a stock using the GGM formula, we need to know:
- D1 = the expected future value of dividends
- K = cost of equity, which the required rate of return by investors
- g = the stable dividend growth rate, in perpetuity
The formula to calculate the fair value of a stock is P = D1 / ( k – g ).
Let’s look at an example.
A technology company has declared a quarterly dividend of $0.85 per share, reaching an annualized dividend of $3.40 for the coming fiscal year. Analyst consensus estimates that the firm will increase its annualized dividend at a constant rate of 4% annually thereafter. The cost of equity for this blue chip technology firm is 12%, and its stock currently trades at $65. Can we use the GGM to calculate the stock’s fair price?
The answer is yes.
P = D1 / ( k – g ) = ( $3.40 x ( 1 + 4% ) ) / ( 0.12 – 0.04 ) = $3.54 / 0.08 = $44.2
According to the GGM, the stock of the technology firm should trade at $44.2. Instead, it trades at $65. This indicates that the stock is overvalued, which means that investor confidence is high for this technology firm, and investors trust their money to it.
Define Gordon Growth Model: GGM is method that investors use to value a stock based on its dividend distributions.