The Gordon growth model is a well known and widely known model for valuing equity securities. However, as with every model, there are some pros and cons that need to be understood before this model is applied. Understanding of these pros and cons will help differentiating between situations wherein it would be prudent to apply the Gordon growth model and situations wherein that would not be the case.
The points in favor of the Gordon growth model i.e. the pros have been listed first:
- Simplicity:The Gordon growth model is extremely simple to explain and understand. It does not take too much intelligence to assume that the dividends are expected go an increasing at a constant rate. This simplicity is what makes this model widely understood and therefore widely used. More complex models have been proposed in place of the Gordon model. But the Gordon model has stood the test of time, because it mimics the dividend pattern exhibited by most companies and it does so while maintaining it’s simplicity.
- Reverse Logic:Gordon growth model need not be applied only to find the correct intrinsic value of the share. Instead, given the current share price, a reverse analysis can be conducted and the growth rate being implied in the current market price can be found out. This helps in stating facts in a manner which is intuitively understandable. For instance, if the result of this backward analysis is that the dividends are expected to grow 20% year on year forever, then we know that this is not possible and the firm is overvalued. When the whole economy grows at an average of 3% to 5% per annum, how can a single firm continue to grow at 20% forever?
- Scope:The Gordon growth model is applicable to most companies, especially if the company has a relatively mature and stable business. Also, the Gordon growth model can be used to find out if the indices are valued correctly or whether the market is amidst a bubble.
At the same time, the points against Gordon growth model i.e. the cons are as follows:
- Precision Required:The Gordon growth model is highly sensitive to changes in inputs. For instance if you change the required rate of return (r) or the constant growth rate (g) even a little bit, then there will be a huge change in the resultant terminal value and therefore the value of the stock. Hence, for the model to be accurate, the inputs have to be forecasted very accurately. The problem is that these inputs cannot be forecasted with a great degree of precision by investors.
- Non Linear Growth Patterns: Also, the Gordon growth model assumes a constant growth rate. This makes the growth of the company’s dividends appear linear. In reality, empirical evidence has proven that dividend growth is seldom linear. The reason behind this is the existence of business cycles. During boom times, companies experience a surge in earnings and pay out generous dividends and during lean times they pay out lesser dividends. Of course, companies make an attempt to smoothen out these dividend payments. However, it is difficult if not impossible. Even the American telecom giant (AT&T) which has always been known for its impeccable dividend payouts had to cut dividends when it fell on rough times. Thus, the dividend payouts are non-linear to say the least and Gordon growth model may not be the best approximation.
As such the Gordon growth model is susceptible to the “garbage in garbage out” syndrome. Even if slightly inaccurate assumptions are used, the results will be way off the mark!
To conclude, it would be apt to say that Gordon growth model has more pros than cons. Analysts must be careful to avoid the pitfalls associated with the use of the model. Overall, it is a handy tool to estimate the value of equity of any company.
