Gordon Growth model
The dividend discount model is a mechanism of evaluating a company on the basis of theory that a stock is worth the discounted sum of all of its future dividend payments. It is employed to value stocks based on the net present value of the future dividends referred ad the Gordon growth model derived by Myron J. Gordon in 1959.
The variables are:
P is the current stock price.
g is the constant growth rate in perpetuity anticipated for the dividends.
r is the constant cost of equity for the company.
D1 is the value of the dividends in the next year.
Some drawbacks with the Gordon Growth model are:
i) The assumption of a steady and perpetual growth rate less than the cost of capital may be unreasonable.
ii) If the stock currently doesn't pay a dividend, like many growth stocks, in general versions of the discounted dividend model must be employed to value the stock. One popular mechanism is to presume that the Miller-Modigliani hypothesis of dividend not relevant is true,and thus replace the stock's dividend with earnings per share(EPS).
But this has the consequence of double counting the earnings. The equation of model identify the trade off between paying dividends and the growth realized by reinvested earnings. It comprises both factors:
Replacing the lack of dividend with earnings
Multiplying by the growth from those earnings
iii) The stock price resultant from the Gordon model is hypersensitive to the growth rate selected.
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