Present Value Models – Gordon Growth Model | CFA Level I Equity Investments

In this lesson, we’ll explore the popular Gordon Growth Model and its extension, the multi-stage dividend discount model. Let’s dive right in and discover how these models help us estimate the price of a stock in the future.

Gordon Growth Model Basics

The Gordon Growth Model simplifies the dividend discount model, assuming that the growth rate of dividends remains constant forever. This allows us to express every future dividend in terms of the current or most recent dividend paid, denoted as D0.

Intrinsic Value = D1 / (r – g)

This formula might seem simple, but watch out for potential pitfalls! Remember that the numerator is the dividend for the following year, which you must multiply D0 by the growth rate to estimate. Don’t fall for exam tricks that use the most recent dividend as the numerator.

Assumptions and Limitations of the Gordon Growth Model

Before using the Gordon Growth Model, keep these key assumptions and limitations in mind:

• Dividends are the correct metric for valuation purposes.
• The dividend growth rate is perpetual and constant.
• The required rate of return remains constant over time.
• The required rate of return (r) must be strictly greater than the dividend growth rate (g).

Stock Value Sensitivity to Changes in r and g

The stock value is sensitive to changes in the difference between r and g. A smaller difference between r and g results in a higher stock value, while a larger difference leads to a lower stock value.

Two-Stage Dividend Discount Model

The two-stage dividend discount model is an extension of the Gordon Growth Model and is often used to model rapidly growing companies with an initial finite period of high growth, followed by an infinite period of sustainable slower growth.

Estimating the Constant Growth Rate (g)

There are three common methods to estimate the constant growth rate of dividends:

1. Using the historical growth in dividends for the firm.
2. Using the median industry dividend growth rate.
3. Using the firm’s sustainable growth rate, which is the return on equity (ROE) multiplied by the firm’s earnings retention rate (1 – dividend payout ratio).

g = ROE x (1 – dividend payout ratio)

Summary of Present Value Models

We have learned the following present value models:

• Dividend Discount Model: Impractical due to estimating every dividend in the future.
• Gordon Growth Model: Assumes dividends will grow in perpetuity at a single constant growth rate. Appropriate for stable, mature, non-cyclical, dividend-paying firms.
• Two-Stage Growth Model: Assumes an initial high growth rate that drops to a stable rate in the future. Appropriate for firms with high current growth rates.
• Three-Stage Growth Model: Assumes three stages of dividend growth (growth, transition, and maturity). Appropriate for firms with an initial high growth rate, followed by a lower growth rate during a transitional period, followed by a constant growth rate in the long run.

For firms that do not pay dividends or have uncertain future dividends, the Free Cash Flow to Equity (FCFE) model may be more appropriate. If none of the models mentioned here are appropriate, valuation based on other models like multiplier models may be more appropriate.

Next, we will move on to multiplier models.