A dividend growth discount model provides a simple approach to value a stock with dividends that grow at a stable rate.
Gordon Discount Model
The Gordon Discount Model requires 3 inputs:
- Expected dividends one year from now (D1)
- Assumed Dividend Growth Rate (GR)
- Your required Rate of Return (RR)
The Value of Stock = ————–
x (RR – GR)
Dividend Stock Valuation Using Intel (INTC)
- Expected Annual Dividend One Year From Now (D1) = $0.89
- Assumed Dividend Growth Rate (GR) = 6% (.06)
- Your Required Rate of Return (RR) = 10% (.10) .
Value of Intel = ————– = $22.25
x (.10 – .06)
If Intel is trading in the general area we can conclude it is fairly valued according to the model. If the price is above $22.25 it may be over valued. If the price is less than $22.25 it may be undervalued and the investor may choose to do further research.
Purpose of Gordon Discount Model
The purpose of a Gordon Discount Model is to estimate the present value of all future dividends. The value of any investment is the expected cash flows, in this case the dividends, discounted at a rate that compensates the holder for the risk taken (Your Expected Rate of Return (RR)).
The Gordon Model stock valuation calculation can help an investor to decide whether a particular investment is worth further research. If an investment is clearly overvalued, you may want to move on to other opportunities. If an investment is undervalued it is a prospective stock for adding to your portfolio.
Limitations of the Gordon Discount Model
Of course anything this simple has to have limitations. This model has severe limitations in the real world. This does not make the model invaluable, but understanding the limitations helps you understand how to use the model effectively. Here are some important limitations:
Model assumes dividend growth remains constant forever. In reality dividends can be cut or grow at different rates.
Model assumes dividend and earnings grow together in the long run. For example, dividends can’t be more than earnings.
Only sustainable growth rates give reasonable results. For example, a 30% dividend growth rate is unsustainable.
The dividend discount model can understate the true value of the stock because it does not evaluate intangible assets owned by the company.
How to Use the Model for Dividend Stock Valuation
Use the Dividend Discount Model to evaluate steady dividend growth companies with reasonable payout ratios and average dividend yields. It is a useful tool to evaluate if a stock is undervalued or overvalued compared to the current market price. The model calculation can be a valuable thinking exercise and add to your insight and understanding of stock valuations.