The constant growth formula uses the dividend growth rate and the required rate of return to calculate the intrinsic value of a stock.
Let us discuss what is the constant growth model and how we can use it to calculate the stock price.
What is Gordon’s Constant Growth Model?
The Gordon Growth Model (GGM) or Constant Growth model is a financial valuation method that calculates the intrinsic value of a stock.
It is a variation of the Dividend Discount Model (DDM) that also offers the same computation framework.
The intrinsic price of a stock is the price that is derived in and from the stock itself. It doesn’t absorb external and economic factors.
The GGM also computes the intrinsic value of the stock without considering the economic and external forces.
It uses the current market price of the stock and considers future dividends growing consistently to derive the intrinsic value of the stock.
Investors can then use this calculated value to decide whether or not to invest in the underlying stock.
Constant Growth Model Assumptions
The constant growth model is a simple framework to calculate the stock price using a few variables. However, this theory has some critical assumptions that we must remember when valuing a stock.
Assumption 01:
The company under consideration operates a stable business model. It has an established revenue stream and there are no significant changes to its operations.
Assumption 02:
The company has stable and reliable financial leverage. It means its capital structure is reliably funded and offers a balanced approach when financing its operations.
Assumption 03:
The company’s growth rate is constant. It is highly unlikely for new and growing firms. However, it can be used for preferred stocks or established businesses easily.
Assumption 04:
All of the free cash flows (FCFs) of the company are paid out in dividends. Thus, the company has a consistent dividend payout approach.
It’s unlikely that all types of businesses will fulfill these assumptions. Therefore, the constant growth model should be applied carefully.
How Does Gordon’s Constant Growth Model Work?
The constant growth model links dividend growth rate, discount rate, and stock valuation. It shows how well a stock is priced in terms of internal factors.
The GGM calculates the stock price by using these internal factors. It does not consider external factors such as market conditions.
The required rate of return (ROR) is the minimum rate expected by shareholders for investing in the stock. The dividend growth rate is the rate at which the dividend amount grows from one year to the next.
The GGM assumes that the business has an infinite life and it issues all of its free cash flows as dividends to its shareholders. Moreover, it assumes that these dividends grow at a constant rate each year.
When an investor has these input values, the stock price can be calculated easily by using the GGM formula mentioned below.
How to Determine the Stock Price with Constant Growth Model?
The formula to calculate the stock price using the constant growth model can be written as:
Stock Price = D1/(k-g)
D1 = Dividend value for the next year or year-end
k = required rate of return
And g = dividend growth rate
If you are evaluating a public company’s stock price (intrinsic value), then you can find these inputs from the published financial statements.
You can use the following simple steps to calculate these inputs for other companies.
D1 is the expected amount of dividend at the year-end or the following year. It will be announced by the company depending on the financial results.
The required rate of return is the cost of equity. It is the rate of return required by investors or it can be calculated by using the dividend growth model.
Required rate of return= (expected dividend payment /current stock price) + dividend growth rate
For simplicity, you can consider the risk-free rate of return as well.
The dividend growth can be calculated by dividing the previous year’s dividend by the current year’s dividend minus one and multiplying the result by a hundred.
Dividend growth rate = [(dividend year 1 / dividend year0) – 1] x 100
Once you have these input values, you can use the constant growth formula to find the intrinsic value of the stock.
Example
Suppose company ABC is currently trading at $50 per share. It announced a dividend of $ 3 per share last year and is expected to announce a dividend of $ 3.25 per share for the next year.
The required rate of return for its shareholders is 10%. What is the Intrinsic Value of the ABC stock?
Let us first calculate the dividend growth rate by using the formula:
Dividend growth rate = [(dividend year 1 / dividend year0) – 1] x 100
Dividend growth rate = [(3.15/3.0) – 1] × 100
Dividend growth rate = 5 %
Now, we can use the GGM formula to calculate the value of stock.
Value of Stock = D1/(k-g)
Value of Stock = 3.25/ (10% – 5%) = 3.25/5% = $65
It means ABC stock is currently undervalued with its current dividend growth rate and shareholder expected rate of return.
When to Use Gordon’s Constant Growth Model
As we mentioned above, the constant growth model has some assumptions. Therefore, it shouldn’t be applied everywhere.
First of all, it is applicable for stocks where the dividend growth rate is less than the cost of equity or the required rate of return to the shareholders.
If both rates are the same, it will give the infinite value of the stock which is unrealistic.
Similarly, if the dividend growth rate exceeds the ROR, it will give us a negative share price which again is an unrealistic situation.
Also, the GGM ignores the impact of debt financing that can change the required rate of return for shareholders substantially. The interesting factor of that debt financing brings down the total cost of capital (ROR).
The constant growth model is applicable where companies are growing at a constant rate. Therefore, we could predict the dividend growth at a constant rate as well.
It is not suitable for companies in the early and growth stages. Here the company would see fluctuating cash flows, inconsistent dividends, and hence a changing stock price of the company.
Advantages of Constant Growth Model
Let us briefly discuss the advantages of the constant or Gordon Growth Model.
Easy to Use
The use and implementation of the GGM are easy. It can be applied to all types of businesses where you have the necessary information.
It is easily used and understood with simple calculations.
Inputs are Available
The input values of the formula are readily available for public companies. You can also calculate these three inputs by using some basic calculations.
So, the formula can be applied easily with the help of only three input values.
Finds the Intrinsic Value of a Stock
The listed price of a stock is available for everyone. The GGM helps understand the investor’s intrinsic value of the stock.
It can help investors understand whether the stock is undervalued or overvalued in terms of its dividend growth and required rate of return.
Can be Used for Established Businesses
The constant growth model calculated the intrinsic value of stocks for established businesses with constant growth rates.
It is because these businesses do not see fluctuating returns and cash flows. Their dividend growth rates are also consistent.
Disadvantages of Constant Growth Model
Despite several advantages, the GGM also comes with some disadvantages.
Ignores External Factors
The constant growth model does not consider the external factors affecting stock prices. For example, it ignores the economic conditions or market trends that directly affect stock prices.
In that sense, it is true to its argument of intrinsic valuation only.
Requires a Constant Growth Rate
If a company is growing at an inconsistent rate, the GGM cannot be applied. In practice, there are very few businesses that grow at a steady pace.
Most businesses go through cyclic changes and see different growth rates.
Assumes All Cash Flows as Dividends
The constant growth rate holds when the company distributes all of its free cash flows as dividends. That in turn would mean an opportunity cost of losing the positive NPV projects.
In practice, businesses do not distribute all of their FCFs as dividends.
Inputs Depend on Several Assumptions as Well
The key inputs of the GGM formula are the required rate of return and dividend growth rate.
Both of these metrics rely on several assumptions. For example, dividend growth is a management decision that can change at any time.
