Whether you’re a shareholder, investor or a young entrepreneur wanting to try out your luck in the big business, you should know the essentials of how to choose the right stock you want to invest in.
And with many things to take into consideration beforehand, it isn’t always easy to make the right move, but we’re here to help.
The way you do this is by assessing the present value of stock using all kinds of methods and keeping track of parameters which give you the information about the value of the company you want to invest in stock and also using formulas and models to calculate the inputs you’ve gathered by doing research on a specific company.
Now, one of the ways you do this is by using the Gordon Growth Model or GGM for short, which tells you how the value of a certain company will grow over a certain period of time.
But before we jump into it, we should first explain some of the basics of assessing the stock in order for you to use this model properly.
STOCK MARKET 101
I remember, back in my junior year of college what I’ve learned from my economy course was just what’s a market and what is supply and demand, and it had nothing to do with stock markets let alone how they function and how to invest your money.
This means that you don’t have to have a Harvard or a Stanford degree in economics in order for you to understand the basics of the stock market and to figure out which companies to invest in and which to avoid.
Basically, there are five components you need to know before even considering investing in stocks:
- Stock – also called and equity is used to represent ownership interests of a company. This means that if you own one or one million shares in stock, you’re an owner of the company on a small or a big scale depending on how many shares you have and your investments.
- Shares – shares represent your investment and are sort of a mutual fund you “share” with other investors. There are a few types of shares which are differentiated by their fee structure, but you don’t have to worry about that for now.
- Stock market – If you’ve heard of Wall Street, than you know what a stock market is. You come here and invest your money into the stock. It’s sort of like gambling but with more risk and a lot more earnings.
- Growth percentage – The percentage at which a company grows in terms of value. We’ll later see how this can be used in your advantage.
- Return rate – A measure of the profit shown as a percentage of investment.
Of course, there are many more parameters to take into consideration, and these are just the ones which help you invest in a stock if you were to stop reading this article right now.
Later we’ll implement some more complex, but easy to understand points.
DIVIDEND DISCOUNT MODEL
Okay, now that we’ve talked about the basics of the stock market, we’re ready to start explaining different models which are used to assess the value of a certain company.
By knowing which model to use, you’ll have an easier time figuring out if you should invest your money.
The Dividend Discount Model or DDM for short is used to evaluate the current stock value. And without having to give an abstract explanation, we’ll give you a practical example.
Let’s say there’s a company, named XYZ and the stock of this company pays a 3% annual dividend, but you want to make 5% annually on your investment. Otherwise, it wouldn’t be worth your time.
This is called the required rate of return, or “r” in the equation.
Next, you’re planning to keep the stock for a long term, and you assume that there is an infinite holding period and a constant dividend.
So now, to calculate the stock price, we will use a simple formula.
P = D / r
Or when you implement the numbers from the example it is:
Stock price = $3 / (0.05) = $60
This formula tells you that if you buy a stock for $60, the annual $3 dividend will ensure you’re getting 5% back on your investment meaning if the Stock XYZ is trading below $60 you should buy it, and if it’s above $60, you should wait until the price comes down.
And this model can be used for any asset which has a constant cash flow. And it doesn’t matter how much the company is worth as far as the dividend won’t change and we’ll hold the stock forever.
Now that we’ve explained this model, it’s time to move on to our main one – the Gordon growth model.
GORDON GROWTH MODEL
A while back, specifically in the 1960s, Myron Gordon, an American economist, developed a model which can be used to estimate the constant growth of a stock of a certain company.
This is a version of the DDM, but instead of showing the current value of a stock, this model is focused on showing the constant growth.
At first, it seems complex, but this is one of the easiest and most used models in calculating the dividend growth rate, and although it’s not quite perfect, it still gets some of the job done anyways.
First things first, there are two basic forms of this GGM formula – the stable model and the multi-stage growth model.
Stable Model Formula
The stable model formula consists of the following parameters:
- Value of stock = D1 / r – g
- D1 = the annual expected dividend of the next year
- r = rate of return
- g = the expected dividend growth rate (assumed to be constant)
Now let’s incorporate this formula into an example and say that a company named ABC intends to pay $1 dividend per share next year and you expect this to increase by 5% per year.
And let’s assume that you want the rate of return to be 10% on the ABC company stock.
So currently the ABC company stock is trading at $10 per share and by using the formula above we can calculate the intrinsic value of one share of the company:
$1.00 / (.10 – .5) = $20
And what this formula is telling us is that the ABC company stock is worth $20 per share but is trading at $10 so the GGM suggests that it’s undervalued.
The stable model assumes that the dividend is growing at a constant rate, which isn’t always a realistic assumption, so now let’s take a look at our next model.
Multistage Growth Model Formula
This model is used to depict a more realistic scenario where the dividends are not expected to grow at a constant rate so you must evaluate each year’s dividends separately and incorporating each year’s expected dividend growth rate.
Now, let’s assume that there’s a company we want to invest in stock, named DEF, and let’s assume that during the next few years the company’s dividends will increase rapidly and then grow at a stable rate. And we will calculate this by using the elements of the stable model, so here are the inputs:
- D1 = $1.00
- r = 10%
- ga (dividend growth rate, first year) = 7%
- gb (second year) = 10%
- gc (third year) = 12%
- gn (dividend growth thereafter) = 5%
So now that we’ve estimated the dividend growth rate we can calculate the dividends of those years so we add 1 and just multiply the growth rate with the dividend (D = D*1 +g):
- Da = $1.00
- Db = $1.00 * 1.07 = $1.07
- Dc = $1.07 * 1.10 = $1.18
- Dd = $1.18 * 1.12 = $1.32
Next we need to calculate the present value of each dividend in the course of the unusual growth period:
- $1.00 / (1.10) = $0.91
- $1.07 / (1.10)2 = $0.88
- $1.18 / (1.10)3 = $0.89
- $1.32 / (1.10)4 = $0.90
Then we value the dividends which will occur in the stable growth period by calculating the fifth year’s period: De = $1.32*(10.5) = $1.39
And after that we apply the Gordon Growth Model formula to determine the value in the fifth year: $1.39 / (0.10 – 0.05) = $27.80
The present value of the stable period dividends are then calculated: $27.80 / (1.10)5 = $17.26
And finally, you add the present value of your company DEF future dividends to get the intrinsic value of the company’s stock: $0.91 + $0.88 + $0.89 + $0.90 + $17.26 = $20.84
After all this hassle we see that the DEF Company’s stock value is undervalued because it has a $20.84 intrinsic value compared to the $10 trading price.
It takes some time to master this model, but with a bit of practice, you’ll be able to calculate the dividend growth of any company in minutes!
CALCULATING INTRINSIC VALUE
Intrinsic value assesses the value of intangible aspects of a company and is used to get some sort of security in your investments.
The Gordon Growth Model helps investors in calculating the value of a share of stock exclusive, which is in the current market conditions.
To calculate this mathematically, you have to have two circumstances in order to use the GGM:
- The company you’re buying stock for must distribute dividends, although analysts apply the GGM even when the stocks don’t pay dividends under the assumption what would happen if the stock did actually pay them.
- The rate of return (r) must be higher than the dividend growth rate (g) because otherwise, the result would be negative.
For example, let’s assume that a phone company (I’m getting tired of using alphabet letters for naming companies) has a stock currently selling for $20, but they’ve changed their packaging and have new managers in charge.
This can improve the company’s competitive advantage in the market, and some investors may calculate that the intrinsic value of the stock is $50 per share meaning $30 more worth than the selling price, making it a great investment.
It’s important to note that the Gordon Growth Model is very sensitive when it comes to changes in both the rate of return and the dividend growth rate.
Using the GGM shows you that a stock becomes more valuable when the dividend is increased, the required rate is decreased or the expected growth rate increases and it implies that a stock price grows at the same rate as the dividends.
THE ADVANTAGES AND DISADVANTAGES OF THE GORDON GROWTH MODEL
Honestly, the Gordon Growth Model has its flaws, but it also has some advantages which make it one of the most used models in calculating dividend growth.
The first advantage of this model is its simplicity but as you will see it can also be a disadvantage because it assumes a single constant growth rate for dividends which, in the real world, often changes from year to year.
This is due mainly because companies often decide either to preserve cash when something bad or unexpected happens, for example, a budget deficit or when sales go down, and also spend cash to make an acquisition. Either way, as you can imagine, the growth rate is affected, at least temporarily.
However, because the growth rate is unpredictable, it means that you can turn this into your advantage by investing in companies that seem to be falling down as long as their growth rate is higher than the rate of return.
Economics are always better explained by an example than by abstraction, so let us take an example which is currently trending in the news.
Recently there was some drama about the Huawei Google ban, and we aren’t going to get all political now, we just need to imagine if Huawei phones stopped using Google Services.
Because Google is the number one search engine on the internet, Huawei phones not being able to use Google Services would result in sales decline because people will be less willing to buy a smartphone which can’t even “google” anything.
Now there are tons of different scenarios which can happen here, but we brainstormed 3 realistic ones:
- Google really gets banned on Huawei and sales go down, resulting in dividend growth rate decline, meaning you should pass from investing in Huawei stocks any time soon.
- Google gets banned, but Huawei manages to keep sales up by using Yahoo or Bing search engines, this means that there will be a small decline in growth rate, but at in the long run, if the return rate is still higher, you should invest.
- Google doesn’t get banned, and nothing happens, which can result in a sudden decline in sales during the period where the ban threats occurred, but after a while, the growth rate will come back to normal and maybe even increase, so you should certainly invest in stocks.
If you want, you can do a little homework and find out what exactly is happening with Huawei and Google now and are sales going up or down or staying the same so you can later calculate the dividend growth rate to see if it’s really worth investing.
Another disadvantage of the GGM is that the formula is very sensitive to changes in return rates and dividend growth rate, which we’ll show you in an example now.
Let’s assume that we have two stocks we want to invest in and that they both pay a dividend of $1 and have a required return of 8%
- Stock A has a 6% (g) meaning that its value is = $1 * 1.06 / (.08 – .06) = $53
- Stock B has a 7% (g) and its value is = $1 * 1.07 / (.08 – .07) = $107
As you can see, the value of stock B is more than double than the value of stock A and just because of a 1% difference.
But that’s not all, because if the growth rate is higher or lower than the rate of return than the difference will be a lot smaller.
If the stocks have a different percentage, for example:
- If stock A has a dividend growth rate of 1% then the value is = $1 * 1.01 / (0.08 – 0.01) = $14.43
- If stock B has a dividend growth rate of 2% the value is = $1 * 1.02 / (0.08 – 0.02) = $17
Although the Gordon Growth Model has some flaws, it is still commonly used, especially by evaluating companies in banking and real estate industries where dividend payments are usually large, and growth rates are relatively stable.
It’s also useful because it relies on inputs that are already available and are easy to estimate but you shouldn’t rely solely on this model to evaluate stock but using it with other models can make a really great tool to quickly get a feel if you should invest in the company stock or not.
To summarize, the Gordon Growth Model is great for easy evaluation of dividend growth rate and should be used for companies with larger dividend growth rate and at your own risk.
The truth is there is no formula or model which can accurately assess the value or the growth of a certain stock, but you should use them to figure out if you should invest in it or not.
At the end of the day, investing in stock is like gambling, but if you know what you’re doing and you do your homework on a company you want to invest a share in, you can always figure out how to do it with the least risk possible.