gordon model

7/31/2019 gordon model

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StrategicCorporate

Finance

Presented by: SHEETAL A. JAIMALANI(52)SHRIJESH K. GOVINDAN(55)KSHITIJ TIWARI(26)NEHA RAWAL(34)



Dividend Theories

Relevance Theories

(i.e. which consider

dividend decision to be

relevant as it affects thevalue of the firm)

Irrelevance Theories

(i.e. which consider dividend

decision to be irrelevant as it

does not affects the value of the firm)

Walter’s Model Gordon’s Model

Modigliani and

Miller’s Model



GORDON MODEL



• According to Prof. Gordon, Dividend Policy almostalways affects the value of the firm. He Showed howdividend policy can be used to maximize the wealth of the shareholders.

• The main proposition of the model is that the value of ashare reflects the value of the future dividends accruingto that share. Hence, the dividend payment and itsgrowth are relevant in valuation of shares.

• The model holds that the share’s market price is equalto the sum of share’s discounted future dividendpayment.



Definition

• A model for determining the intrinsic value of a

stock, based on a future series of dividends that

grow at a constant rate. Given a dividend per share

that is payable in one year, and the assumption that

the dividend grows at a constant rate in perpetuity,the model solves for the present value of the infinite

series of future dividends.

• Because the model simplistically assumes a constant

growth rate, it is generally only used for mature

companies (or broad market indices) with low to

moderate growth rates.



Assumptions of the model:

• The firm is an all equity firm. No externalfinancing is used and investment programmes arefinanced exclusively by retained earnings.

• Return on investment( r ) and Cost of equity(Ke

)are constant.

• The firm has perpetual life.

• The retention ratio, once decided upon, isconstant. Thus, the growth rate, (g = br) is alsoconstant.

• Ke > br



Arguments of this model:

• Dividend policy of the firm is relevant and that investors put a

positive premium on current incomes/dividends.• This model assumes that investors are risk averse and they put a

premium on a certain return and discount uncertain returns.

• Investors are rational and want to avoid risk.

•The rational investors can reasonably be expected to prefer currentdividend. They would discount future dividends. The retained

earnings are evaluated by the investors as a risky promise. In case

the earnings are retained, the market price of the shares would be

adversely affected.

• Investors would be inclined to pay a higher price for shares on

which current dividends are paid and they would discount the

value of shares of a firm which postpones dividends.

• The omission of dividends or payment of low dividends would

lower the value of the shares.



P=E(1 - b)Ke - br

Where:P = Price of a share

E = Earnings per share

b = Retention ratio

1 - b = Dividend payout ratio

Ke = Cost of capital or the capitalization rate

br (or)g = Growth rate

According to Gordon, the market value of a share is

equal to the present value of the future streams of

dividends.



Case A Case B

D/P Ratio 40 30

Retention

Ratio60 70

Cost of

capital

17% 18%

r 12% 12%

EPS $20 $20

P =$20 (1 - 0.60)

0.17 – (0.60 x 0.12) => $81.63 (Case A)

P =$20 (1 - 0.70)

0.18 – (0.70 x 0.12)=> $62.50 (Case B)



Real Estate Bubble

Gordon’s growth model to calculate the value of a sample house.

• Apartment Size: 1800 Sq ft

• Rent Per month in that location: Rs. 19,000

•

Rental Advance: 10 times or Rs. 190,000• Assuming an increase of 15% rental every year, and an Inflation Rate

of 10%, the value of the apartment is Rs. 41,80,000.

• Present value of Interest earned on Rs 190,000 in perpetuity at 15% is

Rs 5,70,000. Total Value of the house is Approximately Rs. 47,50,000.

• The current price of the apartment is Rs. 80,00,000 (approximately).

• So Gordon model is used here to show that the house is overpriced.



Pepsi

• Pepsi yields approximately 3.30% with a current

annual dividend of approximately $2 a share.

• Over the long term, no company can grow faster

than the gross domestic product. The long-termaverage growth in the gross domestic product of

the United States, which is 3%. The cost of equity

is 6%.• Using Gordon’s growth model, Pepsi’s stock has a

valuation of $69 a share.



CitiGroup

• With these factors in mind, we will assume thatCitigroup is in stable growth, and that its currentearnings (estimated for 2000) of $ 13.993 billion

will grow 5% in perpetuity. In addition, we willassume that the payout ratio looking forward willbe 56.40% (the average modified payout ratioover last 4 years) and that the beta for the stock

based upon its business mix is 1.00. With theseinputs, a risk free rate of 5.1% and a risk premiumof 4%.



• Cost of equity for Citigroup

= 5.1% + 1.00 (4%) = 9.1%

• Value of Citigroup’s equity

= $13.993 (1.05) (.564)/(.091-.05)

= $202.113 billion



P = 83.248

0.1672 – 0.05 => Rs. 710.3

EPS 75.68

Divident 110%

75.68* 1.1= 83.248Ke 16.72%

G 5 %

Canara Bank



Stock price calculated from the Gordon growth model is 710.30

The current market price for 52 week is 667.90 which can reach

710.3 if the current dividend growth of 5% is continued.

Canara Bank



Thank You

gordon model

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