what is Gordon Growth Model

The Gordon Growth Model (GGM) is a fundamental tool in financial valuation, providing a simplified method to estimate the intrinsic value of a company's stock based on expected future dividends. Here's a detailed analysis of the model:

1. **Key Assumptions and Limitations**:
- The GGM assumes constant growth in dividend payments, which is rarely observed in real-world scenarios due to business cycles and financial fluctuations.
- The model's main limitation lies in its inability to account for variable dividend payouts, which can lead to significant valuation inaccuracies.
2. **Formula and Calculation**:
- The Gordon Growth Model formula is given by: GGM = Next Period Dividends Per Share (DPS) ÷ (Required Rate of Return – Dividend Growth Rate).
- To calculate the intrinsic value of a stock, one needs the current DPS, the expected dividend growth rate (g), and the required rate of return (r).
3. **Practical Application**:
- The GGM can be used to establish intrinsic value, simplifying the valuation process by disregarding market conditions.
- It is particularly useful for companies with a history of consistent dividend growth, providing a straightforward method to estimate their stock value.
4. **Interpretation of Results**:
- If the model's result is higher than a stock's market price, it indicates that the stock may be undervalued based on the Gordon growth model's intrinsic value calculation.
- Conversely, if the model's result is lower than the market price, the stock may be overvalued.

In conclusion, while the Gordon Growth Model offers a simplified approach to stock valuation, it is essential to recognize its limitations and apply it judiciously. The model is most effective for companies with a stable history of dividend growth and should be used in conjunction with other valuation methods and market analysis to provide a comprehensive view of a company's intrinsic value.