Discuss using Gordon model to calculate cost of equity. List basic assumptions of the method, main results, and potential issues such as “Supernormal Growth”.
Gordon Model is used to have an idea about the intrinsic value of the stock that is estimated by taking help of future series of dividends that have a constant growth rate. A given dividend per share that is payable within a year is required. The major assumption is that dividend has a constant growth rate of perpetuity. Present value of infinite series comprised of future dividends is solved out by the model.
Value of Stock = D / k – G
The above mentioned equation reflects D which is expected dividend per year one year from now
K represents required rate of return for equity investor
G represents growth rate in dividends ( in perpetuity)
The model is a simplified version based on the constant growth rate therefore it can only be used by mature companies in the market. Broad market indices can also be treated with Gordon model if those are associated with low or moderate growth rates.
As far as the assumptions of Gordon Model are concerned these are similar to that of Walter’s model.
The only source of financing that a firm has is that of retained earnings and no external finance is involved in the financing sources
Both the rate of return and cost of capital are constant even when new investment decisions are taken it does not affect the risk involved in the business
No closing down is involved therefore the life of the firm is endless
The growth rate “g” of the firm is calculated by finding out the product of retention ratio “b” and rate of return “r”.
The cost of capital Ke is greater than the growth rate of the firm “g” i.e. Ke>g