Common stock represents ownership of the corporation. So the common stockholders are the owners of the firm. They elect the firm’s board of directors, who in turn appoint the firm’s top management team. The firm’s management team then carries out the day-to-day management of the firm. A share of common stock is more difficult to value in practice than a bond, for at least three reasons. First, with common stock, not even the promised cash flows are known in a advance. Second, the life of the investment is essentially forever, since common stock has no maturity. Third, there is no way to easily observe the rate of return that the market requires. Nonetheless, as we will see, there are cases in which we can come up with the present value of the future cash flows for a share of stock and thus determine its value.
Stock valuation is the process of determining the fair market value of a company’s stock. It plays a pivotal role in investment decision-making, helping investors identify undervalued and overvalued stocks. Accurate stock valuation is essential for maximizing returns and managing risks effectively.
The Growth Theory studies the analysis of corporate and industry data to select reputed concerns that show continuing growth from one business cycle to another and a growth rate that exceeds the overall economy. Embedded in growth theory is that, the investor seeks returns in the form of capital growth rather than dividend income. If an investor can classify and obtain the stock of such companies in their early developmental and growth stages, and the companies go on to become leaders in a growing field, the investor most likely will have impressive results. Another approach of the growth theory is to purchase mutual funds that focus on certain industries which the investor considers to be growth industries. An alternative is to invest in funds with growth or belligerent growth as investment objectives. This way the investor gets professional management in selecting growth stocks. However, if the investor analyzes are fully and invests for long-term, then the growth stock approach will yield handsome results.
Gordon Growth Model or Constant Growth Model of Common Stock Valuation
Gordon growth model serves as a valuation model used to determine intrinsic value of company stock. Myron J. Gordon developed the model in 1962 and is also known as the Gordon-Shapiro model.
The Gordon growth model can be used to value a firm that is in ‘steady state’ with dividends growing at a rate that can be sustained forever. The Gordon growth model relates the value of a stock to its expected dividends in the next time period, the cost of equity and the expected growth rate in dividends.
Value of Stock = DPS1/( ke – g ), where,
- DPS1 = Expected Dividends one year from now (next period)
- ke= Required rate of return for equity investors
- g = Growth rate in dividends forever
While the Gordon growth model is a simple and powerful approach to valuing equity, its use is limited to firms that are growing at a stable rate. There are two insights worth keeping in mind when estimating a ‘stable’ growth rate. First, since the growth rate in the firm’s dividends is expected to last forever, the firm’s other measures of performance (including earnings) can also be expected to grow at the same rate. To see why, consider the consequences in the long term of a firm whose earnings grow 6% a year forever, while its dividends grow at 8%. Over time, the dividends will exceed earnings. On the other hand, if a firm’s earnings grow at a faster rate than dividends in the long term, the payout ratio, in the long term, will converge towards zero, which is also not a steady state. Thus, though the model’s requirement is for the expected growth rate in dividends, analysts should be able to substitute in the expected growth rate in earnings and get precisely the same result, if the firm is truly in steady state.
The second issue relates to what growth rate is reasonable as a ‘stable’ growth rate. This growth rate has to be less than or equal to the growth rate of the economy in which the firm operates. This does not, however, imply that analysts will always agree about what this rate should be even if they agree that a firm is a stable growth firm for three reasons.
- Given the uncertainty associated with estimates of expected inflation and real growth in the economy, there can be differences in the benchmark growth rate used by different analysts, i.e., analysts with higher expectations of inflation in the long term may project a nominal growth rate in the economy that is higher.
- The growth rate of a company may not be greater than that of the economy but it can be less. Firms can becomes smaller over time relative to the economy.
- There is another instance in which an analyst may be stray from a strict limit imposed on the ‘stable growth rate’. If a firm is likely to maintain a few years of ‘above-stable’ growth rates, an approximate value for the firm can be obtained by adding a premium to the stable growth rate, to reflect the above-average growth in the initial years. Even in this case, the flexibility that the analyst has is limited. The sensitivity of the model to growth implies that the stable growth rate cannot be more than 1% or 2% above the growth rate in the economy. If the deviation becomes larger, the analyst will be better served using a two-stage or a three-stage model to capture the ‘super-normal’ or ‘above-average’ growth and restricting the Gordon growth model to when the firm becomes truly stable.
The assumption that the growth rate in dividends has to be constant over time is a difficult assumption to meet, especially given the volatility of earnings. If a firm has an average growth rate that is close to a stable growth rate, the model can be used with little real effect on value. Thus, a cyclical firm that can be expected to have year-to-year swings in growth rates, but has an average growth rate that is 5%, can be valued using the Gordon growth model, without a significant loss of generality. There are two reasons for this result. First, since dividends are smoothed even when earnings are volatile, they are less likely to be affected by year-to-year changes in earnings growth. Second, the mathematical effects of using an average growth rate rather than a constant growth rate are small.
The Gordon growth model is a simple and convenient way of valuing stocks but it is extremely sensitive to the inputs for the growth rate. Used incorrectly, it can yield misleading or even absurd results, since, as the growth rate converges on the discount rate, the value goes to infinity.