This is an article for you who want to learn how to calculate the fair value of a stock using Gordon’s formula. This model is a well-known and proven model.
So, what is Gordon Growth Model (GGM)?
Gordon’s formula is a method of calculating the justified price (fair value) of a stock. It was published in 1956 by the economist Myron J. Gordon and is a well-known and very proven model for calculating target prices for shares. It is sometimes also called Gordon’s growth model, and it has been used extensively since it was first published.
Gordon Growth Model: Definition
Stock analyzes can be done in several different ways. There are, of course, both simpler methods (eg looking at P/E ratios and other key ratios) and slightly more advanced methods (where Gordon’s formula is included).
The advantage of Gordon’s formula is that it can act as decision support and give you an idea of whether to buy or sell a specific stock. In short, it can help you find stocks that are grossly overvalued or undervalued.
The formula is not very advanced purely mathematically, and entering fairly reasonable numbers should not be so difficult either.
But despite this, it still belongs to the slightly more advanced methods of stock analysis, as it actually requires some caution in the assumptions made.
This is because small incorrect assumptions can affect a lot and make a big difference in the result you get. You should therefore see the formula as a way to get a rough estimate of the justified price, and not a specific target price.
Why Gordon’s formula & how difficult is it to use?
The formula is named after Myron J. Gordon (University of Toronto) who published it in 1956. Many people usually mention that the formula is easy to use.
This is because the formula itself is not very difficult to calculate mathematically. It is also not impossible to find a number of reasonable numbers to put into the formula.
But I would still like to say that caution in the use of the formula is important.
What can happen is that small incorrect assumptions can make a huge difference in your results. Therefore, you need to think that the formula gives a rough estimate, not a truth.
But with that said, the formula is a great way to get decision support in whether to buy or sell a stock. Many times I think that the most important thing is the process that you go through in the calculation that helps the most in the decision process.
What does Gordon’s formula look like?
Gordon’s formula is as follows: P = u / (k-g)
The formula is thus relatively simple, but as I said, it is important to be careful in the numbers you enter. Also keep in mind that the model is very sensitive to if k and g are too close to each other, as this can result in a grossly misleading result.
I will now go through what each letter in the formula above means.
P = Reasoned price for the share
The result you get here (after you have completed your calculation) is the justified price (target price) according to what you have entered in Gordon’s formula.
Remember that this result should only be seen as a clue, and not a complete truth.
In addition, one should keep in mind that small adjustments in the included parameters can affect the justified price a lot.
This means that you should make reasonable assumptions so that you get as fair a result as possible.
If, for example, you find that P = $250, while the share is currently at $175, then it may indicate that the share is undervalued and that it is a buying position. On the contrary, it can mean a sell position when the share is judged to be overvalued.
u = The latest dividend
The company’s latest dividend to shareholders – and it must be stated in dollars (not as a percentage, ie not yield).
k = Your required rate of return
This is your (annual) return requirement, and remember to be realistic in your assumptions. A good level can e.g. be 8 percent (0.08), while an unrealistic level is e.g. 25 percent (0.25).
The required rate of return must be stated as a decimal number (ie 8 percent must be stated as 0.08), and not in percentage form.
What value you should put here can be difficult to know as it is not something you can calculate.
You can simply try to make an assessment of what you think feels reasonable.
g = Dividend growth
Here you state what you think the annual dividend growth will be in the future.
This can also be a little difficult to come by. A tip, however, is to look at what it looked like historically, e.g. the last 5 years.
In this way, you can more easily form an idea of what feels reasonable. Do not be too optimistic in your calculations as it may give a misleading result.
Just like the required rate of return, dividend growth must be stated in decimal form (ie 10 percent must be stated as 0.1).
Example of calculation of GGM
We take a simple example of what the calculation might look like with Gordon’s formula.
First, we recall that the formula was as follows: P = u / (k-g)
Gordon’s formula calculation
Dividend (u): $10 (per share)
Your required rate of return (k): 10 percent (per year)
Dividend growth (g): 5 percent (per year)
Reasoned price (P): the answer to the calculation below
Calculation: P = 10 / (0.1 – 0.05) = 200
The justified price (P) for the share in this example is thus $200 per share according to Gordon’s formula.
The cash flow model
From Gordon’s formula, the currently widely used cash flow model has also been developed. Instead of looking at dividends, in this analysis we calculate the present value of the company’s future free cash flows.
The company’s cash flow is defined as operating profit excluding depreciation. From this amount we deduct standard tax and adjust for future investments. It provides the free cash flow which is also called the net cash flow.
Note the difference between profit and cash flow. Large write-downs of, for example, goodwill burden the result, but not the cash flow. Investments in, for example, facilities, on the other hand, affect cash flow.
The cash flow model focuses on three things:
• The company’s cash flow over its estimated useful life
• The company’s risk level
• Investment return requirement or WACC
As a discount factor, the investor’s required rate of return or the term WACC is most often used, which stands for average weighted average cost of capital or in other words: what it costs on average to finance the balance sheet.
With a normal market interest rate and risk level in the investment, the required return / WACC is usually between 5 and 15 percent.
The higher the inflation, the higher the market interest rate and thus also the higher the yield requirement. In the same way, the required rate of return is increased to compensate for a higher risk.
The cash flow model can be summarized by Brealey & Myers’ two principles: a dollar today is worth more than a dollar tomorrow and a safe dollar is worth more than an uncertain one.
Do not use Gordon’s formula alone
Finally, it may be worth noting that it is not a very good idea to use Gordon’s formula alone in his analysis.
It can definitely be used as part of the analysis, but I strongly recommend that you combine it with other things. I want to strike a blow to combine fundamental analysis (FA) with technical analysis (TA) to get as good an idea of the whole as possible.
Within FA there are useful key figures, and within TA there are indicators, which can help you a lot.
Also make sure that you have a decent view of the company’s historical development (last 3-5 years) as it will make it easier for you to make reasonable assumptions about the future development.