In the field of investing, there are quite a few different ways to calculate the economic effects. Some of them relate to government bonds, others explore various aspects of the activities of different companies, determining their attractiveness. Still others are offered as a way of realistic valuation of assets. Of course, there are a number of additional parameters that can be added here, but more on that later. Now in the framework of the article, the most interesting question is: what is the Gordon model? Used for what? What models, what result shows and how to interpret it? What are the formulas?
What is called the Gordon model?
The Gordon Model is a variation of the dividend discount model that is used to calculate the price of a stock or business. It found its main application in calculating the value of companies that are not listed on stock exchanges and which are difficult to evaluate with other economic instruments. You can also find an expanded name - the growth model of Gordon.
What is the formula?
And how, in fact, to simulate some situation? Pretty simple - using math. It should be noted that Gordon’s models can be created for many situations, which, accordingly, will affect the content of the formula. But so that you have an idea of what will be discussed, they suggest disassembling a rather popular equation created for dividend payments, which will be next year with the condition of increasing them by the size of the average growth rate. So, the Gordon model, the formula:
- DSC = (DVTP x (1 + STRD)): SATM + STRD.
The abbreviation is as follows:
- DSC - return on equity of the company.
- DVTP - dividend payments of the current period.
- STRD is the average growth rate of dividends.
- SATM - the current value of the stock, which is estimated by the Gordon model.
Calculation Example
Manual modeling is quite problematic and time consuming. Therefore, auxiliary environments such as Excel are widely used. Suppose that one share of Gazprom costs 150.4 rubles. You can see the calculation example below. Formulas by which it was considered:
- Expected return on equity = B20 x (1 + D7): E7 + D7.
- The average annual growth rate of dividends = (B20: B7) ^ (1: 13) - 1.
Why is it needed?
Gordon’s model can be used to ensure the development of a difficult valuation, during tax planning, as well as during the valuation of shares with a uniform increase in dividends in the stock market. Also, the application is effective in such cases:
- An increase in the market.
- There is a stable supply of raw materials and material resources needed for production.
- The technologies and equipment used are highly efficient, and their replacement is not expected in the next few years, or there are guarantees that modernization will be carried out according to the latest technology in the near future.
- The company has financial resources that can be used to improve it.
- A stable economic situation is observed.
It should be reported that the forecast of dividends in itself is an extremely difficult task due to the existence of various economic risks (which are always there, even if the company had previously been evaluated and received good feedback regarding business stability). So, there are quite a few methods for assessing the size of payments, which aimed to make everything as accurate as possible. Certain restrictions are also imposed. So, the Gordon model is used on the basis that there will be a stable growth rate of dividend payments. By the way, this segment of the economy is so specific that its assessment by other methods is not possible.
Feature of this model
What features can this model provide? The main and most interesting thing is that if certain conditions are met, the equation becomes the full equivalent of the general formula for discounting the flow of monetary units. So, in order to determine the current cost of equity for a business, it is necessary that all expected cash flows of the period of interest be divided by the difference that arises between the discount rate and the growth rate. It should be reported here that at first Gordon was looking for a solution to calculate the profit you can count on. Therefore, at first, these calculations were called the "dividend model." But, in spite of everything, the equation given here is quite general.
By the way, the difference between the discount rate and the growth rate is considered the norm of capitalization. You can also calculate the multiplier (or coefficient) of income. For this, it is necessary to divide the unit by the rate of capitalization. Therefore, it is difficult to disagree with the statement that the Gordon equation is also compatible with the general estimation model. To mathematically determine the attractiveness of a business, revenues are generated by a factor. Due to this property, when accessing the Gordon model, it becomes easier to analyze information on stocks or the state of the entire enterprise / company. The calculations obtained using these formulas can be applied to effectively manage a business or to assess its value. Also in economic literature, one can sometimes find such a term as the “GROWTH model”.
Usage restrictions
It should be noted that with all its advantages, the Gordon model has a rather limited scope. So, only those companies that currently have stable growth rates can make settlements on it. In order to correctly use the information received, the data for determining the growth rate must undergo a careful selection.
Those companies that can boast of their growth, which is equal to the nominal increase in the economy (or have a growth rate less than it), ideally fall under the Gordon model. At the same time, it is necessary to have a clear and formulated policy that relates to dividend payments and which will be implemented in the future.
Conclusion
In conclusion, we can deduce the importance that this economic toolbox provides. It should be remembered that it allows you to evaluate enterprises and companies that are not on exchanges.
Also quite important is its role in establishing the current state of the organization, as well as planning the level of profitability that is expected in the near future. It is also imperative to consider the realities in which you will use everything. Here are several formulas for different cases, and if you are interested in this topic - they will be useful in mastering economic disciplines within the university or self-education.