Given that valuation, if the stock trades around that price, it's a fair value for investors. A price point well above that level suggests the market has overvalued the stock, while one considerably below it implies an undervalued stock.
Pros and cons of the Gordon Growth Model
There are several benefits to using the Gordon Growth Model, including:
- It helps investors put a firm value on a company's stock.
- It's easy to use.
- It's ideal for mature companies that pay steadily growing dividends.
- Investors can use it as an input for more complex dividend-based stock valuations such as the two- and three-stage models.
However, there are also several drawbacks. These include:
- It assumes that a company's dividend will grow at a constant rate in perpetuity. As previously noted, there are other versions that don't make this assumption.
- It's not suitable for companies that don't pay dividends or steadily increase their payouts. For example, the GGM generally has no use in valuing speculative, high-growth stocks.
- There are some potential issues with the relationship between the discount rate (cost of equity capital) and the dividend growth rate. If the required rate of return is less than the dividend growth rate, the model can yield a negative value. Conversely, if they're the same, it pegs a company's value at infinity.
A quick way to value dividend growth stalwarts
The Gordon Growth Model enables investors to quickly value a company that pays a steadily growing dividend. The goal is to provide a basis to determine whether the stock is trading at a fair valuation or not based on expected future dividend payments.
However, it's not a perfect model. Even the best companies don't always deliver bankable dividend growth. So, investors should use this model in conjunction with other methods of analysis in order to form a more informed opinion of a stock's intrinsic value. Even then, using it will still be more art than science, given that the only thing certain about the future is uncertainty.
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