Unlock Stock Valuation: The Power of Gordon Growth Model
Investors, take note. A powerful tool for stock valuation has been around since the 1950s. It's called the Gordon Growth Model, named after its creator, Myron Gordon. Let's dive into how it works and its limitations.
The Gordon Growth Model calculates a share's value by discounting all future dividends back to their present value. It uses a simple formula: P = D ÷ (r - g). Here's what each variable represents:
- P: The current price of the share
- D: Next year's expected dividend
- r: Investor's required return
- g: Long-term growth rate of dividends
To use the model, you'll need estimates for D, g, and r. The model assumes dividends grow at a constant rate and the growth rate is less than the investor's required return. If these conditions aren't met, the model can't be used. For instance, it's unsuitable for stocks that don't pay dividends or where the growth rate exceeds the required return.
Multi-stage models can address these limitations. They break down the valuation into stages, with dividends starting in the future and growing at different rates in each stage.
In essence, the Gordon Growth Model provides a way to value stocks based on expected future dividends. It's a powerful tool, but it's not a one-size-fits-all solution. Understanding its limitations and when to use it is key for investors. As with any valuation method, it's always wise to consider multiple approaches.
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