What an investor pays for a share of stock is an indication of what he expects to receive from that stock. Investors expect two kinds of cash flow when purchasing shares: the stock’s market price at the end of the holding period and the dividends that the company pays during the holding period. Accordingly, Myron J. Gordon, of the University of Toronto, developed the Gordon growth model based on the dividend discount model that values a share according to the discounted value of the sum of these future dividends. Because common stock does not have a maturity date, the Gordon growth model treats the stock's current value as equal to the present value of the share's future dividends for an infinite time period.
You use the Gordon growth model to determine the intrinsic value -- the value as determined by analysts, rather than the market itself -- of a mature company’s stock. A mature company is one that has surpassed the expansion phase during which companies plow earnings back into operations, rather than pay regular dividends. You can then compare the stock's intrinsic value to your required rate of return to determine if the stock is a wise investment. For example, assume the intrinsic value of a share is $20 and its market value is $12. If your safety margin, or preferred "cushion" between the share's intrinsic value and market value, is 40 percent, you will purchase the stock at $12. With a cushion of $4.80, or $12 multiplied by 40 percent, the stock can drop by $4 and you still have saved -- and potentially earned -- $4 at the $12 market price.
According to the Gordon growth model, you value stock by estimating the returns a stockholder will receive over time. Because the cash flows are uncertain and the stock has no predefined maturity date, you can’t calculate a yield to maturity. Instead, you must estimate the stock’s price by calculating the present value of an infinite series of future dividends. You do so by dividing the expected dividends per share in one year by the difference between the investor’s required rate of return and the growth rate of the dividends. For example, assume a stock pays a $10 annual dividend, which is expected to grow 8 percent per year, and the stockholder’s required rate of return is 10 percent. The stock value equals ($10 * (1 + 0.08) / (0.10 – 0.08) = $54.
Requiring only three elements — the expected dividends, the required rate of return and dividend growth rate — the Gordon model provides a simple means to calculate a stock’s value. In addition, the ratio assumes that dividends grow at a constant rate, which simplifies the ratio’s calculation.
By assuming that dividends grow at a constant rate, the Gordon growth ratio ignores the various factors, such as earnings, that affect a company’s dividend payout. For this reason, the model is less suitable for growing companies with fluctuating dividends than for mature companies, which are more likely to have a steady flow of dividend payments. In addition, the model bases its calculation on the expected dividend value in one year, which ignores any periodic variance in dividends paid.
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