Stock Valuation Method through Gordon Growth Model: Formula Unraveled
The Gordon Growth Model (GGM) is a popular formula used to estimate the intrinsic value of a company's stock. The model, however, has its limitations and may not be suitable for all scenarios.
The GGM is designed primarily for companies that issue dividends, excluding most growth stocks. It is also limited to companies with stable growth rates in dividends. In realistic situations where a company's dividends do not grow at a constant rate forever, the firm does not pay dividends, or the cost of capital varies over time, the GGM may not provide accurate results.
More specifically, the GGM is not appropriate for companies with irregular or no dividends, variable dividend growth rates, changing cost of capital, or firms in transition or cyclical industries. Small errors in estimating dividend growth or discount rates can cause large valuation swings with the GGM, limiting its reliability especially for volatile firms.
In contrast, advanced valuation methods like multi-stage dividend discount models or discounted cash flow (DCF) models, which allow for changing growth rates and incorporate free cash flow rather than dividends alone, provide better accuracy in such cases.
One of the key assumptions of the GGM is constant growth in dividends, which is not common for most companies due to business cycles and unexpected financial events. If the required rate of return is less than the growth rate of dividends, the result is a negative value, rendering the model worthless. If the required rate of return is the same as the growth rate, the value per share approaches infinity.
The GGM calculates the fair value of a stock irrespective of market conditions, taking into account dividend payout factors and the market's expected returns. However, it ignores non-dividend factors that can add to a company's value, such as brand loyalty, customer retention, and intangible assets.
In summary, the GGM is best suited for stable, dividend-paying companies with consistent growth. For high-growth, non-dividend-paying, or dividend-unstable firms and situations involving variable discount rates, more advanced valuation methods are recommended.
- Advanced valuation methods like multi-stage dividend discount models or discounted cash flow (DCF) models, which allow for changing growth rates and incorporate free cash flow, offer better accuracy for companies with irregular or no dividends, variable dividend growth rates, changing cost of capital, or firms in transition or cyclical industries.
- The Gordon Growth Model (GGM) is not appropriate for companies with a business model that does not revolve around dividend payouts, as it ignores non-dividend factors that can add to a company's value, such as brand loyalty, customer retention, and intangible assets.
- The GGM may not provide accurate results when applied to businesses with financial structures that are more complex than just dividend payments, such as firms engaged in initial coin offerings (ICOs), token mining, or decentralized finance (DeFi).
- Traders seeking to invest in businesses without a consistent dividend stream, such as those participating in initial public offerings (IPOs) or ventures in the technology sector, might find the GGM less applicable due to its reliance on regular dividend growth.
- The reliability of the GGM is questionable in volatile markets where business liquidity or financial conditions may fluctuate dramatically, as small errors in estimating dividend growth or discount rates can cause large valuation swings, making it less suitable for short-term trading strategies.
