The Gordon model is a methodology used by financial administrators and managers to evaluate the notional value of the company
The Gordon model is a theoretical model that is based on the assumption that the value of the company equals the present value of all future dividends paid over the life of the company, which is assumed to be infinite.
Application excellence
This valuation model is the best for most financiers, because it takes the company as a whole in time
The basic expression to calculate the value of the company at a given time is:
P = D 0 (1 + g) 1 / (1 + K e) 1 + D 0 (1 + g) 2 / (1 + K e) 2 +…. + D 0 (1 + g) µ / (1 + K e) µ
Where:
P = Price per share of common shares.
D i (i = 1, µ) = The dividend per share expected in year i.
K e = Equity capitalization rate.
g = Expected annual earnings and dividend growth rate
The Gordon model assumes that dividends and profits grow in equal proportion. This assumption is true only in cases in which a company distributes a fixed percentage of its profits annually, that is, a fixed payment ratio.
If a constant growth rate is assumed, the expression of the theoretical value of a capital share is obtained:
P = D 1 / K e - g
The problem when using this model is the difficulty of calculating the book capitalization rate (k e) and the profits with their growth rate.
The equity capitalization rate can be calculated using earnings returns which is the inverse of the price-earnings ratio, that is, earnings per share divided by the market price per share.
Another way to calculate this rate is to substitute your historical dividend, share price, and growth rate data into
{P (1 + K e) / (1 + g)} - P = D 0 - {D 0 (1 + g) µ / (1 + K e) µ}
And use the historically-based capitalization rate that results from solving for the Gordon model for the price of securities.
The Gordon Model is one of the most commonly cited valuation models and is far better than other measures of a company's value.
The dividend growth rate can be appreciated by using the historical dividend per share values to calculate the compound annual growth rate.
The Gordon model, which capitalizes the future returns of the company during a supposedly infinite life, is the most correct method theoretically since it considers the company as a going concern and does not use asset values or market prices as annexes in the process. valuation. Instead, it assumes that the value of the business equals the discounted value of all future returns.
Application of the Gordon model
With the resolution of a problem, which can be very frequent for managers and financial administrators, we can realize its applicability.
One company has calculated that its dividends in the following year will be $ 0.65 for each share. By conducting studies based on your historical data and with your expectations for the future, you expect your growth rate in dividends to be 7.5% for each subsequent year, the rate at which the shareholders of the company capitalize their profits is 10.3%. Calculate the theoretical value of the company.
To solve this problem we must apply the expression:
P = D 1 / K e - g
Substituting:
P = 0.65 / (10.3% - 7.5%)
P = 0.65 / (0.103 - 0.075)
P = $ 23.21 for each share.
This is the intrinsic value of the company's values, this based on the assumptions made in the studies done previously. The veracity of this analysis is subject to the projections made by the financier of the company.
