what is Dividend Growth Model (DGM)

The Gordon Growth Model (GGM) is a fundamental tool in financial valuation, particularly for companies exhibiting stable dividend growth. Here's how it works and its limitations: 1. **Basic Premise**: The GGM assumes that a company's dividends grow at a constant rate indefinitely. It's a variant of the Dividend Discount Model (DDM), which discounts the infinite series of future dividends to present value. 2. **Key Assumptions**: - It values a company's stock based on expected future dividends. - Dividend growth is constant over time. - Dividends are paid indefinitely at the expected rate. 3. **Limitations**: - **Constant Growth Assumption**: The model requires a constant dividend growth rate, which is rare in real-world scenarios where business cycles, financial difficulties, or successes can alter dividend payouts. - **Dividend-Paying Companies Only**: It is limited to companies that pay dividends, excluding growth stocks that may not distribute dividends. - **Sensitivity to Discount Factor and Growth Rate**: The model's result can be sensitive to the chosen discount factor and growth rate. If the calculated value is lower than the market price, the stock is considered overvalued, and vice versa. 4. **Calculative Methodology**: The formula for the GGM is P = D1 / (r - g), where P is the current stock price, D1 is the expected annual dividend, r is the required rate of return, and g is the expected dividend growth rate. 5. **Use and Considerations**: The GGM can be a simple yet effective way to establish a stock's intrinsic value, but it should be used with caution due to its limitations. It's essential to consider the company's financial health, market conditions, and growth prospects beyond the model's assumptions. In conclusion, while the Gordon Growth Model provides a straightforward method for valuing stocks based on expected future dividends, it is crucial to acknowledge its limitations and use it in conjunction with other valuation methods and market analysis to make informed investment decisions.