Determining the value of financial securities involves making educated guesses. That's because unforeseen things do occur. Think of natural disasters, regulatory policy reversals, or corporate scandals that can upend previous value growth.
Despite such uncertainties, you can leverage a constant growth rate model (commonly known as the Gordon growth model) to determine your company's stock value. The said formula assumes a relationship between a constant dividend growth rate and your company's share price.
Here, we digest the Gordon growth model to show you how you can use it to calculate the constant growth rate in dividend payments your company can adopt to justify or even boost your stock value.
What is the Gordon growth model?
The Gordon growth model (GGM) is a financial valuation technique for computing a stock's intrinsic value.
The model leverages the current market price and current dividend payout to calculate the expected dividend growth rate that justifies the price. It, however, disregards the prevailing market conditions and other factors that may impact dividend value.
What are the assumptions of the Gordon growth model?
The Gordon growth model formula assumes that the company:
- Boasts a stable business model (i.e. there are no substantial changes in its operations)
- Has reliable financial leverage. This is true more so for preferred stocks and fixed income securities
- Grows at an unchanging rate
- Is an all-equity firm (i.e. only uses retained earnings to finance its investments, not debt)
- Utilizes its free cash flow to pay out dividends
When to use the Gordon growth model
The Gordon growth model, (aka the constant growth rate model), denotes the relationship between discount rate, growth rate, and stock valuation.
It also helps calculate a fair stock value which can indicate whether the company's indices are priced properly. Since the calculation ignores prevailing market conditions, the resulting share price can be compared to similar companies, which helps identify gaps for improvement.
Business owners can also leverage this model to compute the constant dividend growth rate that justifies the current market price.
Unfortunately, the model only applies to dividends with a constant growth rate in perpetuity. Or rather, it's applicable only for stocks of companies with stable growth rates in their dividends per share. This means that if growth is uneven, as is common in startups or businesses with recent IPOs, the formula is essentially unusable.
The formula is also highly sensitive to the discount and growth rates used. That means the stock price can approach infinity if the dividend growth rate and required rate of return have the same value. Alternatively, it can also return a negative value if the growth rate is greater than the required rate of return.
Furthermore, since the formula excludes non-dividend and other market conditions, the company stocks may be undervalued despite steady growth.
Constant growth rate formula
As mentioned, the constant growth formula estimates a fair stock price based on its dividend payouts and growth rate.
The formula states that:
Constant Growth Rate = (Current stock price X r) - Current annual dividends / (Current stock price + Current annual dividends)
Where r is the required rate of return.
How to calculate constant growth rate (aka the Gordon growth model)
To calculate the constant growth rate, you need to determine the necessary inputs. These can include the current stock price, the current annual dividend, and the required rate of return. Then, plug the resulting values into the formula.
Determining the current stock price
If you own a public company, your stock price will be as valued on the stock market. The stock market is heavily reliant on investors' psychology and preferences.
You can, however, use different models to calculate the same value. Think of price-to-earnings ratio (P/E), price-to-book ratio (P/B), price-to-earnings-growth ratio (PEG), and dividend yield values as some examples.
Determining the annual dividends
You decide the annual dividends for your organization usually by forecasting long-term income and computing a percent of that income to be paid out.
In the case of the Gordon Growth Model, the said income will be your company's free cash, which you can then distribute to stakeholders relative to the number of shares they own.
Determining the required rate of return
The required rate of return refers to the return your company seeks on an investment funded with internal earnings, not debt. The resulting value should make investing in your stocks worthwhile relative to the risks involved.
You can determine this rate using the dividend capitalization model, which states that:
The required rate of return=(expected dividend payment /current stock price) + dividend growth rate
For example, say a company pays an annual dividend of $4 per share, and its shares are currently trading at $100. If said company has been constantly raising its dividend payments by 5%, the internal rate of return will equal:
The required rate of return = ($4/$100)+5% = 9%
To determine the dividend growth rate:
- Find a starting dividend value over a given period. It could be 2019 (V2019).
- Find an end dividend value over a second timeframe. It could be 2020 (V2020).
- Next, plug the values in the formula:
Dividend growth rate = [(dividend yearX / dividend yearX) - 1] x100
Let's say that dividend payment for year 2019 was $2.00 and for 2020 it was $2.05.
Dividend growth rate = [($2.05 / $2.00) - 1] X 100 = 2.5%
Once you have all these values, plug them into the constant growth rate formula.
Company X's stocks are valued at $200 per share and pay a $2 annual dividend per share. If the required rate of return (r) is 10%, what is the constant growth rate?
Based on the formula:
Constant Growth Rate = (Current stock price X r) - Current annual dividends / Current stock price + Current annual dividends x 100
Plugging the values into the formula results in:
Constant growth rate = (200 x 10%) - 2 / (200 + 2) X 100 = 8.9%
Stay on top of the key growth metrics with ProfitWell
Calculating the constant growth rate and determining whether to raise your dividend payouts is essential to justify or increase your stock value.
But for you to attain such a rate (if you haven't already), your revenue (income earnings) must increase at similar or higher rates. Hence the need to consistently track revenue metrics and other contributory factors, including sales, marketing, and product.
Enter ProfitWell Metrics, by Paddle.
ProfitWell Metrics not only helps you accurately report, but also unifies analytics, churn analysis, and pricing strategy into one dashboard. The goal is to provide a clear view of what drives growth and revenue within your company and what needs changing.
Constant growth rate model FAQs
Is the Gordon growth model the same as constant growth model?
The 'constant growth model' and the 'Gordon growth model' are two names for the same approach to evaluating shares and company value. It is also referred to as the 'growth in perpetuity model'.
What is the constant growth rate rule?
The constant growth rate rule is a tenet of monetarism. It requires the Federal Reserve to aim for a money growth rate that equals that of real GDP.
What are the three inputs of the Gordon growth model?
The three inputs of the Gordon growth model are the current stock price (it could be its market price), the expected dividend payout for the following year, and the required rate of return.
What is a constant growth stock?
A constant growth stock is a share whose earnings and dividends are assumed to increase at a stable rate in perpetuity.