Friday, June 13

Equity Valuation using Gordon Model

Gordon Model

Current Price = DPS1 / (Ke – g)
DPS 1 = Dividend expected to be paid out next year

Ke = Cost of Equity (using CAPM as discussed in the previous post "Discount Rate in DCF valuation")

g = Growth rate (RoE X Retention ratio) [discussed earlier in "Discount Rate in DCF Valuation"]

While the Gordon growth model is a simple and powerful approach to valuing equity, its use is limited to firms that are growing at a stable rate. There are two insights worth keeping in mind when estimating a 'stable' growth rate. First, since the growth rate in the firm's dividends is expected to last forever, the firm's other measures of performance (including earnings) can also be expected to grow at the same rate.
Growth rate has to be less than or equal to the growth rate of the economy in which the firm operates.
In summary, the Gordon growth model is best suited for firms growing at a rate comparable to or lower than the growth rate in the economy and that have well established dividend payout policies that they intend to continue into the future. The dividend payout of the firm has to be consistent with the assumption of stability, since stable firms generally pay substantial dividends1. In particular, this model will under estimate the value of the stock in firms that consistently pay out less than they can afford and accumulate cash in the process.

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