The two-stage Gordon Growth Model, devised by Myron J. Gordon, is a financial tool employed by investors and analysts to estimate the intrinsic value of a company. This model comprises two distinct stages: a high-growth phase characterized by a constant growth rate, followed by a perpetual growth phase with a lower, stable growth rate. Notably, the model assumes that the company’s earnings per share (EPS) will grow consistently at the specified rates during each stage.
Two-Stage Gordon Growth Model
The two-stage Gordon growth model is a financial model used to calculate the intrinsic value of a stock. It assumes that the company’s earnings will grow at a constant rate during the first stage, and then at a different constant rate during the second stage.
Structure of the Model
- Stage 1:
- Constant growth rate g1 for a period of n years
- Dividend per share at the end of year n: D1 = D0 * (1 + g1)^n
- Stage 2:
- Constant growth rate g2 indefinitely
- Dividend per share at the end of stage 2: D2 = D1 * (1 + g2)
Assumptions
- The company’s earnings will grow at a constant rate during each stage.
- The dividend payout ratio is constant.
- The firm’s cost of equity (r) is greater than the growth rate in stage 2 (g2).
Formula
The intrinsic value of the stock according to the Gordon Growth Model is:
PV = D1 / (r - g2)
where:
- PV is the present value of the stock
- D1 is the dividend per share at the end of stage 1
- r is the cost of equity
- g2 is the growth rate in stage 2
Example
Suppose a company has a current dividend of $2.00 per share, and its earnings are expected to grow at a rate of 5% for the next five years. After that, the growth rate is expected to slow down to 3%. The company’s cost of equity is 10%.
D1 = $2.00 * (1 + 0.05)^5 = $2.2554
PV = $2.2554 / (0.10 - 0.03) = $30.07
Therefore, the intrinsic value of the stock according to the Gordon Growth Model is $30.07.
Question 1:
What is the concept behind the two-stage Gordon growth model?
Answer:
The two-stage Gordon growth model is a valuation method that assumes a company’s growth rate will decline from a constant high growth rate to a constant terminal growth rate in the future. The model uses these growth rates to calculate the intrinsic value of the company.
Question 2:
How is the terminal growth rate calculated in the two-stage Gordon growth model?
Answer:
The terminal growth rate is calculated by dividing the constant cash flow growth rate in perpetuity by the discount rate minus the constant cash flow growth rate.
Question 3:
What are the assumptions of the two-stage Gordon growth model?
Answer:
The two-stage Gordon growth model assumes that the company’s growth rate will change abruptly from a period of rapid growth to a period of stable growth, its dividends will grow at a constant rate during both the growth and terminal stages, and the discount rate is constant over the entire time horizon.
Well, there you have it, folks! The two-stage Gordon growth model unpacked and deconstructed for your financial literacy enjoyment. We hope you found this article informative and engaging. Remember, investing is all about understanding the market and making informed decisions. So, keep reading, stay curious, and don’t forget to check back soon for more financial wisdom from your friendly neighborhood financial experts. Till next time, keep growing your wealth wisely!