Gordons model assumes a perpetual growth in dividend. As per this approach , the rate of dividend growth remains constant.
Gordons model is used to calculate the intrinsic value of shares based on the future series of dividends that grow at constant rate. As dividend grows at constant rate ,it is generally used for companies with stable growth rate.
Further, earnings, dividends and equity share price all grow at same rate. Thereby potential investor eyeing stable inflows will take the latest dividend payout and factor it with his expected rate of return.
1.What are the assumptions of Gordons Model?
Gordons model is based on the following are the assumptions :
- Firm is an equity firm
- IRR remains constant
- Ke remains constant because change in discount rate will affect the present value
- Perpetual earnings
- No taxes
- Further, no external financing
- Cost of capital (Ke) is greater than growth rate
2.Limitations of Gordons Model
However, This model is not widely used by potential investors because of following reasons:
- there are more parameters which need to be factored in, and
- dividends rarely grow perpetually at a steady rate.
3.What is the formula of Gordons model?
Gordons model is used to calculate the intrinsic value of stock .
P1 = D1/Ke-g
Whereas,
P1 = Stock price
D1 = [D0x(1+g)] i.e. next expected dividend
Ke= Cost of equity capital
g= Constant Growth Rate of Dividend
4.Example:
Starlite Limited is having its shares quoted in major stock exchanges. Its share current market price after dividend distributed at the rate of 20% per annum having a paid-up shares capital of ₹10 lakhs of ₹10 each. Annual growth rate in dividend expected is 2%. Further, the expected rate of return on its equity capital is 15%. Calculate the value per share based on Gordons’ model.
Dividend distributed during the year = 10,00,000 X 20/100 = ₹2,00,000
Dividend per share = ₹2,00,000/1,00,000 = ₹ 2 per share
P1 = D1/Ke-g
= ₹ 2(1+0.02)/0.15-0.02
= ₹15.69
5.Formula for computing cost of equity under Gordon’s model approach:
Following is the formula for computing cost of equity:
Cost of equity (Ke) =D1+g /P0
Whereas,
D1 = [D0x(1+g)] i.e. next expected dividend
P0 = Current Market Price Per Share
g= Constant Growth Rate of Dividend
In case of newly issued equity shares where floatation cost is incurred , the cost of equity share with an estimation of constant dividend growth is calculated as below:
Cost of equity (Ke) = D1+g /P0-F
Where, F= Flotation cost per share
6.Example – How to compute Cost of equity
A ltd has paid dividend of ₹ 2per share (of face value of ₹ 10 each) last year and it is expected to grow @ 10% every year . Calculate the cost of equity by Gordon’s model approach.
Ke = D1+g /P0-F
= [₹2(1+0.1)]+0.1/₹55.
= 0.14 i.e. 14%
7.How to compute growth rate under Gordon’s model?
The calculation of ‘g’ (the growth rate) is an important factor in calculating cost of equity share capital.
Further, Gordon’s growth model attempts to derive a future growth rate. Moreover, as per this model, increase in the level of investment will give rise to an increase in future dividends.
Further, this model takes earnings retention rate (b) and return on investments (r) into account to estimates future growth rate.
It can be calculated below:
Growth (g) = b x r
Where,
b= earning retention rate*
r= rate of return on fund invested
*Proportion of earnings available to equity shareholders which is not distributed as dividend.
Refer:https://taxandfinanceguide.com/cost-of-capital/ and https://taxandfinanceguide.com/capital-asset-pricing-model/
