Gordon’s Model- Explanation, Formula, Problems, Solutions, Etc.

Gordon's Model accounts for uncertainty factors by applying a correction factor to the forecast based on causal factors. This correction factor represents the composite impact of all uncertainty factors. The model divides factors that influence sales into two categories: causal factors and uncertainty factors. Causal factors are those that have a direct impact on sales and can be quantitatively measured. These include population size, income levels, number of competitors, and pricing. Gordon's Model assumes these factors will remain relatively stable over the forecast period. Uncertainty factors are those that are unpredictable and cannot be easily quantified. These include changes in customer preferences, new product introductions by competitors, and economic conditions.

Gordon’s Model is a very important topic in detail for the UGC-NET Commerce Examination.

In this article, the learners will learn about Gordon’s Model in detail and other relevant topics.

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Gordon Growth Model

The Gordon Growth Model is a type of valuation model used to estimate the intrinsic value of a stock. It was developed by Myron Gordon in the 1960s and is based on the dividend discount model.

The model assumes that a stock's dividend will grow constantly into perpetuity. Based on this assumption, the model estimates a stock's intrinsic value as the present value of all its future dividend payments, discounted at an appropriate rate.

Mathematically, the Gordon Growth Model is expressed as follows.

Intrinsic Value = Dividend per share / (Discount rate - Growth rate)

Where the following means.

• Dividend per share is the company's next expected dividend payment per share
• A discount rate is the rate of return an investor requires to make an investment
• worthwhile, also known as the cost of capital
• The growth rate is the expected constant long-term growth rate of the company's dividends

The intuition behind the model is straightforward. If a company's dividends are expected to grow at a constant rate indefinitely, then the only variable that needs to be estimated is that long-term growth rate.

The model's limitations include the assumptions of a constant dividend growth rate and infinite growth, which may not be realistic for all companies. The model is also sensitive to the discount and growth rates' inputs. Despite these limitations, the Gordon Growth Model provides an intuitive and easy-to-use approach for valuing stocks based on expected future cash flows to shareholders through dividends. The model works best for stable, mature companies with a long dividend payment and growth record.

The Gordon Growth Model offers a simple approach for calculating a baseline intrinsic value for dividend-paying stocks. However, the output should only be considered one input among many to arrive at a reasonable valuation.

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Gordon Growth Model Background

The Gordon Growth Model, also known as the Gordon-Shapiro Model or the Dividend Discount Model (DDM), is a method used to value a stock by assuming that dividends will grow at a constant rate indefinitely. The model was developed by Myron J. Gordon and Eli Shapiro in the early 1960s as an extension of the original Dividend Discount Model introduced by John Burr Williams in the 1930s.

Background and Development

Dividend Discount Model (DDM)

The foundation of the Gordon Growth Model lies in the Dividend Discount Model, which is based on the principle that the intrinsic value of a stock is the present value of its future dividends. John Burr Williams introduced this concept in his groundbreaking work, "The Theory of Investment Value," published in 1938.

Gordon and Shapiro's Contribution

Myron J. Gordon and Eli Shapiro expanded on the Dividend Discount Model by incorporating the assumption of a constant growth rate in dividends. They presented their model in a 1956 paper titled "Capital Equipment Analysis: The Required Rate of Profit." This extension addressed the limitations of the original model, which assumed constant dividends.

Key Assumption - Constant Dividend Growth

The key innovation of the Gordon Growth Model is the assumption of a constant growth rate in dividends. This assumption allows for a more realistic representation of many companies that have a history of stable dividend growth. 

Widespread Application

The Gordon Growth Model gained popularity due to its simplicity and applicability to companies with a stable and predictable dividend payout. It became a widely used tool for investors and financial analysts for valuing stocks, particularly those of mature companies that are expected to maintain a steady dividend growth rate.

Limitations and Considerations

While the Gordon Growth Model is valuable for certain types of companies, it has limitations. It assumes a constant growth rate, which may not hold for all companies. Additionally, it does not consider changes in the dividend growth rate over time. Analysts using the model must carefully evaluate whether its assumptions align with the characteristics of the company being analyzed.

The Gordon Growth Model remains a fundamental tool in the valuation of dividend-paying stocks, providing a straightforward approach to estimating the intrinsic value based on expected future dividends and a required rate of return. Despite its simplicity, analysts often use it in conjunction with other valuation methods to gain a more comprehensive understanding of a company's financial prospects.

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Gordon Model Formula

The Gordon Model Formula is a way to estimate the intrinsic value of a stock by discounting the expected future dividends of the stock back to the present. The formula is:

P = D1 / (r - g)

where:

• P is the estimated intrinsic value of the stock
• D1 is the expected dividend per share in one year
• r is the investor's actually required rate of return
• g is the expected dividend growth rate

The Gordon Model Formula assumes that the stock's dividends will grow at a constant rate in perpetuity. This means that the value of the stock is equal to the present value of an infinite stream of dividends.

To use the Gordon Model Formula, you need to know the expected dividend per share, the investor's required rate of return, and the expected dividend growth rate. Once you have these numbers, you can plug them into the formula to estimate the intrinsic value of the stock.

Here is an example of how to use the Gordon Model Formula:

Let's say you are considering buying a stock that currently pays a dividend of $1 per share. The investor's required rate of return is 10%, and the expected dividend growth rate is 5%.

To estimate the intrinsic value of the stock, you would plug these numbers into the Gordon 

Model Formula:

P = $1 / (0.10 - 0.05) = $20

This means that the intrinsic value of the stock is $20. In other words, if you were to buy the stock for $20, you would be getting a fair return on your investment.

The Gordon Model Formula is a simple but powerful tool for estimating the intrinsic value of a stock. It is especially useful for stocks that pay dividends and have a history of stable growth. However, it is important to remember that the formula is just an estimate, and the actual value of the stock may be different.

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Difference Between Walters and Gordon's Model

Walter's Model

• Assumes that the value of a company is determined by the present value of its future dividends.
• Allows for the company to adjust its dividend payout ratio over time.
• Requires that the company's internal rate of return (IRR) and cost of capital (K) remain constant.

Gordon's Model

• Assumes that the company's dividend growth rate is constant.
• Requires that the company's cost of capital (K) be greater than its dividend growth rate (g).

Gordon Model Problems and Solutions

The problems are stated below.

• The assumption of constant dividend growth. The Gordon model assumes that the company's dividend will grow at a constant rate forever. This is not realistic because dividend growth rates can change over time. For example, a company might have a high dividend growth rate in the early years, but then the growth rate might slow down as the company matures.
• The assumption of a constant cost of capital. The Gordon model also assumes that the company's cost of capital will remain constant. This is also unrealistic because the cost of capital can change over time. For example, if interest rates go up, then the company's cost of capital will go up.
• The sensitivity of the model to the inputs. The Gordon model is very sensitive to the inputs, such as the dividend growth rate and the cost of capital. This means that even small changes in these inputs can lead to large changes in the company's estimated value. For example, if the dividend growth rate is 5% instead of 4%, then the company's estimated value could be doubled.

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The solutions are stated below.

• Use a different dividend valuation model. Other dividend valuation models do not assume constant dividend growth. These models, such as the Walter model, are more complex than the Gordon model but may be more realistic.
• Use a range of values for the inputs. Instead of using a single value for the dividend growth rate and the cost of capital, you can use a range of values. This will give you a range of possible values for the estimated value of the company.
• Use a sensitivity analysis. You can use a sensitivity analysis to see how the estimated value of the company changes when the inputs are varied. This will help you to understand how the model works and to identify the inputs that have the greatest impact on the estimated value.

Assumption of Gordon Model

The assumptions have been stated below.

• The company's dividend will grow at a constant rate forever. This means that the dividend will be the same next year, the year after that, and so on, forever. This is not realistic because dividend growth rates can change over time.
• The company's cost of capital will remain constant. This means that the company's cost of capital will be the same next year, the year after that, and so on, forever. This is also not realistic because the cost of capital can change over time.
• The company will continue to pay dividends forever. This means that the company will never stop paying dividends. This is not realistic because companies can go bankrupt, or they can choose to stop paying dividends.

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Gordon Revised Model

The Gordon revised model is a variation of the Gordon model that takes into account the fact that the company's dividend growth rate may not be constant forever. The model assumes that the dividend growth rate will decline linearly over time. This means that the dividend growth rate will be higher in the early years and lower in the later years.

The Gordon revised model is a more realistic model than the Gordon model because it takes into account the fact that dividend growth rates can change over time. However, the Gordon revised model is also more complex than the Gordon model.

The formula for the Gordon revised model is stated below.

P = D1 / (r - g_0 - g_1)

Where the following means.

• P is the estimated value of the company.
• D1 is the expected dividend per share in one year.
• r is the investor's required rate of return
• g_0 is the initial dividend growth rate
• g_1 is the rate at which the dividend growth rate declines

To use the Gordon revised model, you need to know the expected dividend per share, the investor's required rate of return, the initial dividend growth rate, and the rate at which the dividend growth rate declines. Once you have these numbers, you can plug them into the formula to estimate the value of the company.

Here is an example of how to use the Gordon revised model:

Let's say that you are considering buying a stock that currently pays a dividend of $1 per share. The investor's required rate of return is 10%, the initial dividend growth rate is 5%, and the rate at which the dividend growth rate declines is 2%.

To estimate the intrinsic value of the stock, you would plug these numbers into the Gordon revised model:

P = $1 / (0.10 - 0.05 - 0.02) = $33.33

This means that the intrinsic value of the stock is $33.33. In other words, if you were to buy the stock for $33.33, you would be getting a fair return on your investment.

The Gordon revised model is a more realistic model than the Gordon model, but it is also more complex. If you are new to valuation, you may want to start with the Gordon model. However, if you are comfortable with the Gordon model and you want a more realistic estimate of the value of a company, then you can use the Gordon revised model.

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Conclusion

The Gordon model is a simple and easy-to-use model that can be used to estimate the value of a company. The model assumes that the company's dividend will grow at a constant rate forever. This is not realistic because dividend growth rates can change over time. However, the Gordon model can still be a useful tool for estimating the value of a company as long as you are aware of its limitations. The best model to use depends on the specific circumstances of the company. If the company's dividend growth rate is likely to remain constant, then the Gordon model may be a good choice. However, if the company's dividend growth rate is likely to change over time, then a more complex model, such as the dividend discount model, maybe a better choice.

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