Gordon Growth Model - A great method to value dividend stocks

Touzibozhu
Dividend Discount Model Dividend Investing Gordon Growth Model Stock Valuation

Introduction

The Gordon Growth Model, commonly known as GGM, is a simplified form of the dividend discount model that is used for estimating the intrinsic value of dividend-paying stocks. The GGM is a straight-forward but effective model that calculates the intrinsic value of a stock based on the present value of its future dividends, which are assumed to grow at a constant rate. It is particularly suited to dividend-paying stocks with stable operations that have a consistent and sustainable dividend payout policy.

Gordon Growth Model

To use the GGM, you need to estimate three variables:

    1. The expected dividend per share in the next financial period (D1)

    1. The expected growth rate of dividends (g)

    1. The required rate of return (r)

The formula for GGM is as follows:

Equation for Gordon Growth Model
Equation for Gordon Growth Model

where P0 is the theoretical intrinsic value of the stock.
D1 is the expected dividend to be paid in the next financial period.
Ke is the expected return on investment for equity investors.
g is the sustainable growth rate in dividends.

Ke is generally estimated using the Capital Asset Pricing Model with the following equation:

Equation for Expected Rate of Return
Equation for Expected Rate of Return

The formula for GGM describes the relationship between the current stock price, its expected dividend in the next financial period, the expected return on equity for investors, and the sustainable growth rate of dividends. Here we can see the simplicity of the Gordon Growth Model, in that it requires only three parameters to solve for the fourth one. The GGM has great appeal to value investors who are keen on generating constant passive income through dividend investing.

The appeals of GGM

The appeals of the Gordon Growth Model are:

    1. It provides investors with a sound basis for estimating the intrinsic value of a dividend-paying stock.

    1. It is user-friendly and straightforward.

    1. It is most suitable for mature companies with steadily increasing dividends.

    1. It can be used as input for more intricate dividend-based stock valuations, like the two- and three-stage models.

Despite the simplicity of the model, it is generally considered to be suitable for estimating the intrinsic value of stable growth companies with a consistent dividend policy, especially if applied within the constraints of the model's assumptions.

Implicit assumptions in GGM

The assumptions implicit in the model are:

    1. The company has a stable business model that generates stable, predictable income.

    1. The company has a consistent dividend policy that mandates a stable payout ratio, thereby allowing the dividend growth rate to approximate the earnings growth rate over time.

    1. The company has a stable, predictable growth rate that translates into consistent growth in dividends over time.

    1. The company maintains a consistent level of financial leverage. Changes in financial leverage will affect the company's growth rate in earnings.

    1. The company pays out as much dividend as it can afford. In other words, the company pays out the majority of its free cash flow as dividends.

The Gordon Growth Model, like any tool, has its limitations. In order to use the GGM effectively and correctly, it is important to understand the limitations of the model.

Limitations of GGM

The limitations of the GGM include:

    1. The most significant challenge lies in the assumption that a company's dividends will grow at a constant rate. In reality, such constancy is rare, making this a potential drawback.

    1. The model is highly sensitive to the growth rate and discount factor applied. The model yields a negative stock value if the expected dividend growth rate is higher than the required rate of return on investment. Conversely, if the dividend growth rate equals the expected rate of return, the model yields an infinite value to the company, which is conceptually unsound.

    1. The Gordon Growth Model does not take into account external market conditions or non-dividend factors, potentially resulting in stocks being undervalued despite their brand recognition and steady growth.

    1. The model treats the required return on investment as static. In reality, investor expectations of returns on investment vary with time and economic conditions.

    1. The model is only applicable to stable-growth dividend-paying stocks. It does not work for non-dividend-paying, high-growth stocks.

Using GGM to estimate intrinsic value

Example 1 - How to estimate the intrinsic value of a dividend-paying stock.
Using the GGM to estimate the intrinsic value of the Sasseur Reit stock.
D1, estimated forward dividend per share = 0.062 S$
g, conservatively estimated to be 1.5%, i.e. half the long-term CPI target rate in China.
Ke = Rf + Beta x RPm
where Rf = 3.42% (10-year Singapore Government Bond Yield)
Beta = 0.74 (Yahoo Finance)
RPm = Market Risk Premium = 8.98% (According to Market Risk Premia, this is the MRP for the Singapore stock market in November 2008, at the height of the global financial crisis.)
Hence, Ke = 3.42% + 0.74 x 8.98% = 10.07%

Plugging the values into the GGM formula yields an intrinsic value estimate of 0.723 S$.
At this current price of 0.62 S$, the stock of Sasseur Reit is trading at a significant discount to its estimated intrinsic value.

Using GGM to estimate implied rate of return

Example 2 - How to estimate the implied rate of return on investment for a dividend-paying stock.
Using the GGM to estimate the implied rate of return on investment for Sasseur Reit stock.
Rearranging the GGM formula, the expected rate of return on investment, k, can be estimated as:
Ke = (D1/P0) + g
Ke = (0.062/0.62) + 0.015 = 0.115 or 11.5% per annum
In other words, an investor purchasing Sasseur Reit stock at the price of 0.62S$ can expect to earn a rate of return of 11.5% per annum over the long term.

Conclusion

Given the simplicity of the GGM, it is little wonder that the model is popular amongst income investors looking to invest in undervalued dividend-paying stocks. However, it is important to understand the many assumptions implicit in the model and the various limitations of the GGM so that it can be an effective technique in the value investor's tool belt.