Gordon Growth Model (GGM)

What Is the Gordon Growth Model (GGM)?

The Gordon Growth Model (GGM), also known as the Dividend Discount Model (DDM), is a method used to value a company’s stock by assuming that dividends will continue to grow at a constant rate indefinitely. It is widely used for valuing companies that pay regular dividends.

Gordon Growth Model Formula:

The formula for the Gordon Growth Model is:

P = D1 / (r-g)

Where:

P = Price of the stock today
D1 = Expected dividend
r = Required rate of return
g = Growth rate of the dividends

Example of the Gordon Growth Model

If a stock is expected to pay a dividend of ₹5 next year (D₁), dividends are expected to grow at a constant rate of 3% per year (g), and the required rate of return is 8% (r), the value of the stock would be:

P = 5/ (0.08 - 0.03)
P = 5/0.05
P = ₹100

Advantages of the Gordon Growth Model

1. GGM helps calculate the intrinsic value of a stock,allowing them to assess whether a stock is overvalued, undervalued, or fairly valued compared to its market price. This insight helps investors decide whether to buy, hold, or sell a stock.

2. The GGM is simple to understand and apply, making it accessible for both individual investors and financial analysts.

3. GGM emphasizes the long-term growth of dividends, making it suitable for long-term investors. It provides a framework for valuing stocks based on future income streams rather than short-term market movements.

Disadvantages of the Gordon Growth Model

1. GGM cannot be applied to companies that don’t pay dividends or reinvest their earnings back into the business for growth. This limits its use, especially for valuing growth stocks or startups.

2. The model is sensitive to the required rate of return (r) and dividend growth rate (g). Small changes in these variables can lead to significant differences in stock valuation, which may result in unreliable estimates.

3. GGM is purely based on dividends and doesn’t account for market sentiment, external economic factors, or industry trends

4. The model assumes a constant required rate of return, which doesn’t account for the fact that a company’s risk profile may change over time due to internal or external factors.