Gordon Growth Model

What is Gordon's Growth Model? Let's Understand it. Gordon's Growth Model is a method to determine the intrinsic value of a stock based on a series of future dividends that grow at a constant rate. The formula is: P = D1 / (r−g) Where: P = Price of Intrinsic Value of the stock D1 = Dividend expected next year r = Required rate of return g = Growth rate of dividends ♦ Key Assumptions • Constant Growth Rate: Dividends are expected to grow at a constant rate indefinitely. • Stable Required Return: The required rate of return remains stable over time. • Perpetual Dividends: The company is assumed to continue paying dividends forever. ♦ Example Let's say we have a company, XYZ Corp, with the following characteristics: Expected dividend next year (D1): $2 Required rate of return (r): 8% or 0.08 Constant growth rate of dividends (g): 4% or 0.04 P = 2 / (0.08 − 0.04) = 2 / 0.04 = 50 So, the intrinsic value of XYZ Corp's stock is $50. ♦ Pros and Cons Pros • Simplicity: Easy to understand and apply. • Focus on Dividends: Aligns with a value-investing philosophy that dividends reflect a company's financial health. • Long-Term Perspective: Suitable for stable companies with predictable dividend growth. Cons • Assumption Sensitivity: Small changes in r or g can significantly impact the valuation. • Applicability: Not suitable for companies that do not pay dividends or have highly variable dividend growth. • Constant Growth Rate: The model assumes a perpetual and constant growth rate, which is unrealistic for many firms. ♦ Use Cases • Mature, Dividend-Paying Companies: Investors use Gordon's Growth Model to value stocks of mature companies with a history of paying and increasing dividends. • Valuation Benchmarking: The model provides a benchmark to compare the intrinsic value with the current market price to identify undervalued or overvalued stocks. #linkedin #finance #investment Parth Verma

𝐋𝐢𝐧𝐤𝐢𝐧𝐠 𝐏𝐫𝐢𝐜𝐞-𝐭𝐨-𝐄𝐚𝐫𝐧𝐢𝐧𝐠𝐬 𝐑𝐚𝐭𝐢𝐨 𝐚𝐧𝐝 𝐆𝐨𝐫𝐝𝐨𝐧 𝐆𝐫𝐨𝐰𝐭𝐡 𝐌𝐨𝐝𝐞𝐥 Investors often look at the Price-to-Earnings (P/E) ratio to decide if a stock is priced right. It compares a company's stock price to its earnings, helping us see if we're getting good value for our money. Here i will explain how to link the pricing with fundamentals. The Gordon Growth Model helps us get a better view of the P/E ratio by considering how much a company earns, its dividends, and how fast it's expected to grow. 𝐖𝐡𝐲 𝐭𝐡𝐞 "𝐉𝐮𝐬𝐭𝐢𝐟𝐢𝐞𝐝 𝐏/𝐄 𝐑𝐚𝐭𝐢𝐨" 𝐌𝐚𝐭𝐭𝐞𝐫𝐬 The "justified P/E ratio" has two main uses: [1] Forecasting: It helps predict if a stock is a good buy by comparing the expected P/E ratio with the current one. [2] Checking Growth Expectations: It checks if the growth rate suggested by the current P/E ratio is realistic. 𝐓𝐲𝐩𝐞𝐬 𝐨𝐟 𝐏/𝐄 𝐑𝐚𝐭𝐢𝐨𝐬 [1] Trailing P/E: Looks at earnings from the past 12 months. [2] Leading P/E: Focuses on expected earnings for the next 12 months. These give insights into a company's past performance and future prospects. Applying the Model The model finds the right P/E ratio by looking at how much of its earnings a company reinvests and how much it pays out as dividends. Example: Tata Consultancy Services (TCS) Let's see how this works with Tata Consultancy Services (TCS): [1] Cost of equity: 12% [2] Median payout ratio (last 5 years): 35% [3] Dividend growth (last 5 years): 11% This gives us: 𝐋𝐞𝐚𝐝𝐢𝐧𝐠 𝐏/𝐄: 35%/(12%-11%) = 35𝐱 𝐓𝐫𝐚𝐢𝐥𝐢𝐧𝐠 𝐏/𝐄: 35%*(1+11%)/(12%-11%) = 38.8𝐱 TCS's 𝐜𝐮𝐫𝐫𝐞𝐧𝐭 𝐏/𝐄 𝐢𝐬 32.9𝐱, hinting it might be undervalued, which is why the company is buying back shares. 𝐊𝐞𝐲 𝐓𝐚𝐤𝐞𝐚𝐰𝐚𝐲𝐬 Looking at TCS's justified P/E ratios versus its current P/E ratio helps us understand stock value better. Knowing how to use the P/E ratio and the Gordon Growth Model can make a big difference in choosing the right investments. This knowledge is valuable whether you're just starting or have been investing for years, helping you make smarter decisions. #valuation #pricing #dividendstocks

Gordon Growth vs Exit Multiple – Which Terminal Value Approach Should You Use? In a DCF, the terminal value often makes up more than half the valuation. So choosing the right method shapes the entire outcome. There are two main approaches. Each has its place. Each carries its risks. 1) Gordon Growth (Perpetuity Method) - Assumes the business will grow at a constant rate forever. - Terminal Value = Final Year Cash Flow × (1 + g) / (WACC – g) ✅ Works best for mature, stable businesses ✅ Transparent and grounded in cash flow fundamentals ❌ Very sensitive to small changes in ‘g’ and WACC ❌ Can feel unrealistic if long-term growth is not steady or predictable 2) Exit Multiple Method - Applies a trading multiple (like EV/EBITDA or EV/EBIT) to the final forecast year. - Based on how similar businesses are valued in the market. ✅ Easier to justify with current market data ✅ Often used in private equity and real-world deal comps ❌ Can feel arbitrary if comps are not reliable ❌ Ignores long-term reinvestment and growth assumptions So, which one should you use? - Use Gordon Growth when the business is stable and expected to operate indefinitely with modest growth. - Use Exit Multiple when the model horizon matches a likely exit event or when market comps are clear and defensible. In practice, it is sensible to calculate both. Follow Dr. Bhumi for Investment Banking Careers and Education