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Evaluation of Gordon Growth Model
Gordon growth model is commonly known as dividend discount model; it is used to determine the fundamental stock value based on the anticipated future dividends that experience as a constant rate of growth (Farrell, 1985). The model is based on the assumption that the rate of dividend growth is constant. The model further assumes that the firm has a stable business model and hence no significant changes in business operations that can be experienced during a financial year. Moreover, the model assumes that a firm has stable financial leverage and that firms free cash flows tends to be paid to stock owners as dividends (Christie, 1990). Despite dividend growth model being fundamentally crucial in determining the fundamental stock value it tends to have several limitations. For example, the assumption that firms tend to have a constant rate of dividend growth is not likely to be the case in the actual situation. The other limitation with the model is that it tends to be highly sensitive to growth rate and discounting rate. When the growth rate is lower than the rate of growth, the fundamental value of the stock tends to be negative. Also, the model tends to exclude other market conditions that are not attributed to dividends and hence it may end up making the stock to be over and undervalued (Pilbeam, 2018).
Some of the importance of dividend as the basis of determining the value of common stock is that future dividend is estimated to determine the fundamental value of stocks. Besides, the growth of dividend has significant impacts on the value of the stock and hence depending on the firm dividend policy firms with higher cash flows tends to have a strong ability to pay higher dividends. Usually, payment of dividend tends to increase the value of the company. A company that pays its shareholders higher dividends their shares tend to have a higher value as compared to those firms that do not have a dividend payment policy. Therefore, the dividend is an essential component in determining the value of the firm stock. The higher the value of the dividends the more likely that the value of the firm share would be higher depending on the discounting rate applied (Kathari, and Shanken, 1990). The growth rate used in the Gordon growth model can be determined using the formula below; P = D1 / (k-g)
P is the intrinsic/ fundamental stock value
D1 is the anticipated dividend per share
K is the required rate of return of the common stock
G is the rate of dividend growth
By making g the subject of the formula it become possible to determine dividend growth rate as follows
By making substituting
p p p
Therefore, based on the constant Gordon model, dividend growth rate can be obtained by making growth (g) the subject of the formula. Then divide anticipated dividend per year with the fundamental stock value you and subtract the results from the common stock required rate of return then you will get dividend growth rate (Rappoport, 1986).
The rate of growth of the firm earnings translate into growth of its share price over a year in that, the growth of firm earnings makes the form to have adequate cash flows which are distributed as dividends to ordinary stockholders. Higher dividends payments make investors to be motivated to buy the stocks of a firm that pays a higher dividend and hence leading to a higher demand of the firm stocks (Cecchetti, and Schoenholtz, 2017). Increase in demand for the company shares leads to a rise in the price of shares which consequently translate into growth of share price (Schiller, 1981).
A mathematical example to explain why an investor that is primarily concern with capital gains would estimate a firm’s current market price on the basis of expected future dividend will be as follows Dn/(1+r)^-n=P
Where D1 is the dividends, P is the stock market price while r is the discounting rate
$2.00 / (1.10) = $1.980
$2.07 / (1.10)2 = $2.505
$2.18 / (1.10)3 = $2.902
$2.32 / (1.10)4 = $3.397
The pricing of stocks to yield relate to the changing expectations about the level of growth in dividends in the sense that firms that pay higher dividends tend to look attractive in the short run, but in the long run, it becomes risky. Shareholders future expectations tend to change whenever they see that the firm has reduced the amount of dividends payments as they think that the performance of such firm is declining and hence some may end up selling off their shares. However, internet research studies indicate that where a company reduces the number of dividends, it pays to shareholders and use the money to make more investment, over time the value of the share price and dividend tends to experience tremendous growth which positively changes the future expectations of the investors. Changes in stock to yield relate to the risk of investing in the stock of a retail firm in the sense that firm that continuously increases dividend payments may end up collapsing because instead of using some of its profits to expand and enhance its investment it uses such earnings in paying dividends. Therefore, when it fails to pay dividends in the future shareholders who anticipate dividends may end out selling of their shares.
Explanation of how stock prices are related to events in the UK economy and reasons why changes in stock prices tend to lead or follow events or changes in the economy
One of the current events in the UK has been Brexit and Eurozone. Brexit involves the United Kingdom signed to come out of the European Union. Brexit has been one of the fundamental events that have adversely affected the stock prices. Such events may affect rise and fall in consumers wealth; it affects investors confidence as they fear economy breakdown and also affect investments (Schwert, 1989).The Brexit announcement made the stock prices to decline significantly because it was news which was directly adsorbed on the stock prices. Usually, stock prices tend to follow the events of changes in the economy because such event tends to have a significant impact on the underlying value of the stock (Cutler, Poterba, and Summer, 1989).
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