The above can be hard to visualize - so, I made a small example to help explain what we're doing here. (keeping in mind the list of caveats at bottom) The present value of a company's projected earnings is then considered the ‘fair market value’ of the stock. When valuing a stock using DCF, you can estimae all future earnings of a company, and then use the discount rate to find the present value. Once future cash flows are discounted back to present value, one can determine whether or not a given investment is a good idea. In general, DCF uses future cash flow estimates and discounts them back to present day (using a discount rate). Even then, using it will still be more art than science, given that the only thing certain about the future is uncertainty.Using discounted cash flow (DCF) to value a stockĭCF is a valuation method used to value a project, company or asset. 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 the best companies don't always deliver bankable dividend growth. 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. The Gordon Growth Model enables investors to quickly value a company that pays a steadily growing dividend. Conversely, if they're the same, it pegs a company's value at infinity.Ī quick way to value dividend growth stalwarts If the required rate of return is less than the dividend growth rate, the model can yield a negative value. There are some potential issues with the relationship between the discount rate (cost of equity capital) and the dividend growth rate.For example, the GGM generally has no use in valuing speculative, high-growth stocks.

It's not suitable for companies that don't pay dividends or steadily increase their payouts.

As previously noted, there are other versions that don't make this assumption.

It assumes that a company's dividend will grow at a constant rate in perpetuity.

However, there are also several drawbacks.

Investors can use it as an input for more complex dividend-based stock valuations such as the two- and three-stage models.

It's ideal for mature companies that pay steadily growing dividends.

It helps investors put a firm value on a company's stock.

There are several benefits to using the Gordon Growth Model, including: A price point well above that level suggests the market has overvalued the stock, while one considerably below it implies an undervalued stock. Given that valuation, if the stock trades around that price, it's a fair value for investors. Using this information, we can calculate the stock's value using the Gordon Growth Model: For example, say a company expects to pay $2.50 per share in dividends over the next year, has a long track record of increasing its dividend 5% annually, and will likely continue to do so. The Gordon Growth Model uses a relatively simple formula to calculate the net present value of a stock. Meanwhile, the H-DDM includes both initial and terminal growth rates for the dividend. Similarly, the three-stage model accounts for a third phase of dividend growth.

Instead, they account for a change in the dividend growth rate, which affects the present value discount factor and therefore the calculated present value of the stock.įor example, the two-stage model assumes the dividend grows at a steady rate during the first phase of its life before transitioning to a different rate for the remainder. However, they don't assume a constant growth rate for the dividend. The three-stage dividend discount modelĮach of these variations shares some similarities with the Gordon Growth Model.It's worth noting that there are several variations of the GGM. Investors can then compare that value to the stock's current market price to see if it's worth buying. This formula calculates a stock's value today based on expected future dividends.

Trminal growth rate of stock