What Is the Constant Growth Model for Valuing Stocks?

The Constant Growth Model, also known as the Gordon Growth Model, is a fundamental concept in finance for valuing stocks. It estimates a stock’s intrinsic value by analyzing anticipated future dividend payments. This approach assumes dividends increase at a steady, predictable rate indefinitely. It helps investors gauge if a stock’s current market price aligns with its theoretical fair value based on its dividend capacity.

Defining the Key Inputs

The model relies on three inputs to determine a stock’s intrinsic value. The first is the dividend expected in the next period (D1), representing the dividend payment shareholders anticipate receiving one year from the current date. D1 is used instead of the most recently paid dividend (D0) because the model discounts future cash flows. D1 is typically calculated by growing the current dividend by the expected constant growth rate (D0 (1+g)).

The second input is the required rate of return (‘r’). This rate signifies the minimum return an investor expects to earn from an investment, compensating for the risk involved. It links to the cost of equity, the return a company needs to satisfy investors. Investors often estimate this rate using models like the Capital Asset Pricing Model (CAPM), considering the risk-free rate, stock’s beta, and market risk premium.

The third input is the constant growth rate of dividends (‘g’). This is the perpetual rate at which dividends are expected to grow. The model assumes this rate remains consistent over an extended period. Estimating ‘g’ involves analyzing historical dividend growth, analyst forecasts, or calculating the sustainable growth rate, which ties into profitability and retained earnings.

Applying the Valuation Formula

The model consolidates these inputs into a single formula to calculate a stock’s intrinsic value (P). The formula is expressed as P = D1 / (r – g). P denotes the stock’s theoretical fair value today, which the model aims to calculate. D1 in the numerator is the expected dividend for the upcoming year.

The denominator is the difference between the required rate of return (r) and the constant growth rate of dividends (g). This difference is sometimes referred to as the capitalization rate. The calculation essentially discounts the perpetually growing stream of future dividends to their present value. If the calculated intrinsic value (P) is higher than the market price, the stock may be considered undervalued; if lower, it may be considered overvalued.

Fundamental Assumptions

The Constant Growth Model rests on several fundamental assumptions for its mathematical validity. A primary assumption is that the company’s dividends will grow at a steady, perpetual rate (g). This implies a consistent dividend policy and predictable earnings growth.

Another assumption is that the required rate of return (‘r’) must always be greater than the dividend growth rate (‘g’). If ‘r’ were equal to or less than ‘g’, the denominator in the formula would become zero or negative, leading to an undefined or nonsensical stock valuation. This relationship is important for the model to yield a finite and positive stock price.

The model also presumes that the company will continue to pay dividends indefinitely, implying a perpetual existence. This long-term outlook is inherent in the concept of discounting an infinite stream of future payments. It also implies stable business operations, meaning the company is mature with predictable cash flows, allowing for consistent dividend payments and growth.

When the Model is Most Applicable

The Constant Growth Model is well-suited for specific types of companies and market conditions. It applies best to mature, stable companies with a long, consistent history of paying dividends. These companies typically exhibit predictable earnings and cash flow, supporting a steady dividend policy.

The model’s reliance on dividends as its core input means it is designed for companies that distribute earnings to shareholders. It cannot value companies that do not pay dividends, such as growth-oriented businesses reinvesting all earnings. For non-dividend-paying stocks, other valuation methods would be more appropriate.

Companies with stable and predictable dividend growth rates are ideal candidates. Businesses with volatile or unpredictable growth patterns are not good fits, as accuracy diminishes when the constant growth assumption is violated. Its utility is maximized when applied to firms in established markets with minimal risk of dividend cuts or significant changes in their payout policies.