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After doing this activity, students will be able to learn the limitations in Gordon Growth model and provide logical reasoning in support of author’s view in this article.
Dividend Growth Model:
One of the simplest stock valuation models is the dividend growth model, often attributed to Gordon (1962). For instance, suppose that a firm pays dividends once a year and that after 1 year, when that dividend is paid, the stockholder plans to sell the investment. It is assumed in this model that the dividend per stock is constant. But, it should not be thought that this model assumes that the investor holds the stock for an infinite period of time. After whatever period the stock is held for, it will be purchased by another whose valuation is based on holding it for another finite period and who, in turn, will sell it on to another who will similarly hold it, and so on. The effect of this is that the stock is held by a series of owners for a period approaching infinity and the price at which it passes between them reflects the infinite time horizon of that dividend stream. Thus, this model is not sensitive to how long the present stockholder intends to hold the stock. The main problem with this simple dividend model are the assumption of constant dividend growth rate (g) and required rate of return (k) over an infinite time horizon and their estimation. An assumption of a constant growth in dividends may easily be incorporated into the model. Let the annual growth in dividends grow at a compound rate, g and constant required rate of return by investors represented by k. If k>g and as D1 = D0(1 + g), the equation will become as:
P0 = D1/(k – g)
Extracted from: Barnes, P. (2015) Dividend Growth Model. Wiley Encyclopedia of Management.
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The Gordon Growth Model, also known as the dividend discount model (DDM), is a method for calculating the intrinsic value of a stock, exclusive of current market conditions. The model equates this value to the present value of a stock's future dividend.
Value of stock = D1/ (k - g)
D1 = next year's expected annual dividend per share
k = the investor's discount rate or required rate of return, which can be estimated using the Capital Asset Pricing Model or the Dividend Growth Model (see Cost of Equity)
g = the expected dividend growth rate.