Gordon Growth Model cont.§The GGM model should reflect long term growth expectations – GDP growth, industry life cycle stages and the impact of the five force model §The model’s intrinsic values V0 are very sensitive to the input variables for r and g §Sensitivity analysis may be required to obtain a range of values rather than a specific point estimate of value DDM: Constant Growth (Gordon) nAssumptions: 1)Dividend (D1) expected in one year 2)Dividends grow at constant rate (g) forever 3)Growth rate less than required return (r > g) n Situations in which model is useful: 1)Mature (late in life cycle) firms 2)Broad-based equity index 3)Terminal value in more complex models 4)International valuation 5)Can be used to calculate P/E ratio (SS12)
A firm paid a dividend yesterday of $1.50 and dividends are expected to grow at a long term constant rate of 5%. The required return is 10%. §Calculate the intrinsic value Correct answer nV0 = ($1.50 × 1.05)/(0.10 – 0.05) = $31.50 n §Incorrect answer nV0 = ($1.50)/(0.10 – 0.05) = $30.00 n The numerator was not increased by 5%
always use D1/(r-g) and D1=D0 * (1+g)… This is also the same difference that shows up when you do a leading P/E vs. a trailing P/e ratio. P/E1 = Leading P/E ratio And D1=E1*(1-b) where b = Retention Ratio, so (1-b) = Dividend Payout Ratio So P/E1 = (1-b)/(r-g) P/E0 = (1-b)(1+g)/(r-g) This is the linkage from the Gordon Growth model to the P/E chapter…