Assumptions, Key Inputs & Advantages and Disadvantages of the Constant Growth Model

-
Gordon Growth Model Formula Assumptions

Before applying the Gordon Model, there are certain assumptions you need to consider. Otherwise, the model may not produce the expected outcome.

Below are some of those assumptions:
  • It is assumed that the company’s life is indefinite.
  • We also have to assume that the growth of the firm is at a constant rate.
  • The firm’s financial leverage is stable, or it doesn’t have any financial leverage attached to it.
  • The required rate of return is higher and better than the growth rate.
  • The required rate of return of the firm remains constant.
  • The company’s free cash flow is paid out as dividends at consistent growth rates.
Key inputs of the GGM:
                                              This growth takes into account three critical inputs, which are growth rate in dividends per share, dividends per share, and the required rate of return. They are the three components that make up the GGM formula mentioned above.


Let’s look at each of the three key inputs in details:
Dividends per share (D) – This input talks about the yearly payments, which a firm offers to its common equity shareholders. It is represented with the letter “D,” as seen in the formula above.
The growth rate in dividends per share (g) – Here is another parameter you will find on the formula given above. It is called the growth rate and looks at the level at which the rate of dividends per share rises, year to year. It is represented with the letter “g” in the Gordon Growth Model formula.
The required rate of return (r) – This input concerns the minimum rate of return, which investors are ready to accept when purchasing the stock of the company. Furthermore, there are diverse models an investor can use to estimate it.
What the Gordon Growth Model assumes is this. Remember that we said that the model only works for firms whose dividends grow at a constant rate. So the model assumes that a firm exists indefinitely and pays dividends for each share, which rises at a steady rate.
Despite the condition of the market, this model still calculates a stock’s fair value and takes into account different factors. These include the market expected returns and dividend payout factors.

Advantages of the Gordon Growth Model:

  •  Simplicity:

This valuation model is super easy to understand and apply. The reason for this is that its inputs are available, and you can even assume them by accessing the firm’s financial statements or annual report.

  • Efficient

You will find the model more efficient for more stable firms, particularly those that have limited business expenses and good cash flow.

  • Scope

The model has widespread application in the real estate sector, and its proving to be a handy tool for investors and agents alike.

Disadvantages of the Gordon Growth Model

  • Precision Required

One of the drawbacks or limitations the model has is the assumption of steady growth in the dividend. Even the best companies in the world might have challenges to maintain a constant growth rate due to factors like changes in the market, financial difficulties, among others.

  • Not Useful for all Companies

The model is not useful for companies with financial leverage or those with unstable cash flows.

  • Negative Value Result

The model can result in a negative value if the required rate of return is very less than the growth rate.

Comments

Post a Comment

Popular posts from this blog

Risk of a Single Asset

-
Image
 Risk of a Single Asset: The concept of risk can be developed by first considering a single asset held in isolation. We can look at expected-return behaviors to assess risk, and statistics can be used to measure it.  Risk Assessment: Sensitivity Analysis (Scenario Analysis) and Probability Distributions can be used to assess the general level of risk embodied in a given asset. Sensitivity Analysis: Sensitivity analysis uses several possible-return estimates to obtain a sense of the variability among outcomes. One common method involves making pessimistic (worst), most likely (expected), and optimistic (best) estimates of the returns associated with a given asset. In this case, the asset’s risk can be measured by the range of returns. The range is found by subtracting the pessimistic outcome from the optimistic outcome. The greater the range, the more variability, or risk, the asset is said to have. Although the use of sensitivity analysis and the range is rather crude, it does...
Read more

Types of Corporates bonds

-
Image
Types of Corporates bonds:  There are five basic categories of corporate bonds: public utilities, transportations, industrials, banks and finance companies, and international issues. The five categories can be further broken down. For example, the transportation category includes airlines, railroads, and trucking companies. Security of bonds Security for bonds suggests some kind of underlying asset that backs up the issue. This is preferable for investors, as it provides risk protection against a potential corporate  default . Assets backing the bond provide security beyond the credit of the issuer. M ortgage bond A mortgage bond is a secured bond issued by a company. With a mortgage bond, the company pledges specific assets as a collateral for the bond. The asset securing the bond is described in detail in the mortgage deed, which is a legal document giving the bondholder a lien on an asset. A company can use a specific asset as security for more than one bond issue. In the e...
Read more

Secured Bond

-
Image
What are Secured Bonds? A secured bond is a  bond  that requires the issuer to pledge specific assets as collateral in the case of default. Secured bonds are usually more popular with businesses or governments that are less likely to be able to pay their debts in the future. Interest on these bonds isn’t enough to attract investors. Companies and local governments will less than stellar past financial track records usually need to assure inventors that they will not default on their future principle and interest payments. And if they do default, ensure the investors don’t walk away empty handed.   Example A good example of a local government that will probably need to issue secured bonds in the future is the city of Detroit. Since its 2013 bankruptcy, its difficult to believe an investor would want to put his or her money at risk purchasing a bond issued by the city of Detroit. I doubt it will ever be able to issue a bond without having some kind of secured collateral agr...
Read more

Unsecured Bonds

-
Image
What are Unsecured Bonds? Unsecured bonds or debentures are bonds that are not backed by some type of collateral. In other words, the bond is only secured by the bond issuer’s good credit standing. There are no building, equipment, vehicles, or other assets backing up the bond. If the bond issuer defaults on the unsecured bond, the bond holders could receive nothing from their investment. They would be left up to the court system to sue the bond issuer for their investment.  A bond that has no specified source of collateral is considered an unsecured debt instrument. Therefore, unsecured debt often pays higher yields than secured debt due to lack of a direct collateral coverage. There are three types of unsecured debt: debentures, Income bonds and subordinated debentures. Debentures A debenture is a type of bond that does not use collateral. It's otherwise recognized as any unsecured long-term debt. Because the bonds are unsecured, it's imperative for the issue to be profitable...
Read more

Constant-Growth Model

-
Image
Constant-Growth Model The most widely cited dividend valuation approach, the constant-growth model, assumes that dividends will grow at a constant rate, but a rate that is less than the required return. The constant-growth model is commonly called the Gordon model. The Gordon Growth Model – otherwise described as the dividend discount model – is a stock valuation method that calculates a stock’s intrinsic value. Therefore, this method disregards current market conditions. Investors can then compare companies against other industries using this simplified model. The Gordon Growth Model (GGM) is used to determine the intrinsic value of a stock based on a future series of dividends that grow at a constant rate. It is a popular and straightforward variant of the dividend discount model (DDM). The GGM assumes that dividends grow at a constant rate in perpetuity and solves for the present value of the infinite series of future dividends. Because the model assumes a constant growth rate, it i...
Read more