Set out what the Gordon growth model does well and badly and argue for using it to value a firm's common shares
The idea
The constant-growth model is simple, transparent and easy to explain. It suits mature dividend-paying companies with stable payout policies and growth close to that of the economy, and it is also used for broad market indices and for terminal values in multistage models. It links value to three fundamentals: next year's dividend, the required return and the growth rate. Its limitations follow from its assumptions. It cannot value companies that pay no dividend, pay erratic dividends or whose growth is expected to change, and it breaks down as growth approaches the required return. Small errors in r or g produce large valuation errors. The trap is applying it to a fast-growing company whose current growth cannot possibly last for ever.
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- Contrast dividends, residual income and free cash flow as DCF inputs and say in which investment settings each one fits
- Work out the value of a common share with the dividend discount model (DDM) over one holding period and over several, and explain the result
- Value a common share with the Gordon growth model, explaining what that model assumes
- Value perpetual preferred stock that pays a fixed rate and cannot be called
- Use the current share price and the Gordon growth model to back out the implied dividend growth rate, and explain it
- Work out PVGO (the present value of what future growth opportunities are worth) and the share of the leading P/E it accounts for, and explain both
- Derive justified leading and trailing P/Es from the Gordon growth model and explain what they mean
- Back out a required return from any DDM, including the H-model and the Gordon growth model
- Judge from a DDM value whether the market is pricing a stock too high, too low or fairly
- Explain the growth, transition and maturity phases a business passes through
- Explain what spreadsheet modelling, the H-model, the two-stage DDM and the three-stage DDM assume, and argue for choosing one to value a firm's shares
- Explain terminal value and the different ways of setting it in a DDM
- Value common shares with the H-model, the two-stage DDM and the three-stage DDM, and explain the results
- Explain how spreadsheet models are used to project dividends and value common shares
- Work out a firm's sustainable growth rate and explain it, showing how DuPont analysis can be used to estimate that rate