Friday, April 17

Equity Valuation - Gordon Model

Gordon Model (Constant Growth rate)
The Gordon model assumes a constant growth rate for infinity.

The value of the stock is given by:
V = D1 / (Re - g)

D1 = Expected dividend at the end of the year
Re = Required rate of return on equity
g = Expected growth rate for a long period of time (mathematically, infinite period)

For example, A Ltd. Reported earnings per share (EPS) of Rs 15 last year and paid out 52% of its earnings as dividend. The earnings and dividends are expected to grow at the rate of 8% in the long term as in the past. If the required rate of return on equity shares of A Ltd. is 12%, the value of the security is calculated as follows;

EPS = Rs 15
The Current dividend per share is given by the payout ratio times the EPS. Dividend per share (D0) = 15 x 0.52 = Rs. 7.8
So the expected dividend would be given by multiplying the current dividend with the expected growth rate.
Dividend per share (D1) = 7.8 x 1.08 = Rs. 8.42
Expected growth rate = 8%
Required rate of return = 12%

V = 8.42 / (0.12 - 0.08) = 210.50

There are two major limitations of this model
a) This model is used only when the growth rate is constant.
b) This model does not function when the growth rate is equal to or exceeds the required rate of return. Try and calculate the value of the security in the above example assuming the growth rate is 13%! The price would be negative Rs. 842. Equity shares cannot have negative value. More so, if the growth rate is equal to the required rate of return, the value of the security approaches infinity.

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