Stock Valuation: Gordon Growth Model - UMass

[Pages:30]Stock Valuation: Gordon Growth Model

Week 2

Approaches to Valuation

? 1. Discounted Cash Flow Valuation

? The value of an asset is the sum of the discounted cash flows.

? 2. Contingent Claim Valuation

? A contingent claim can be replicated and, thus, priced using other traded assets whose prices are known.

? 3. Relative Valuation

? A company may be priced by comparing its price to another company that has similar characteristics (P/E, Price/Book, etc.)

Discounted Cash Flow (DCF)

? What is the net value today of a series (positive or negative) of (future) cash flows?

? Assumption: The asset has an intrinsic value that is based on its cash flows and risk characteristics.

? Examples:

? Stock: What is the value of a stock that is expected to give a certain amount of dividend every year?

? Bond: what is the value of a bond that gives a certain amount of coupon and principal payments?

? Enterprise: What is the value of the firm as a whole (including the value of equity, debt, and any other securities, like convertible bonds, used to finance the firm)?

DCF and Stock Valuation

? To value a stock using DCF, we can proceed in two possible ways.

? First, we may value the entire firm as a whole by discounting the cash flows that accrue to the business, before interest is paid. The value that belongs to the shareholders is what is left after the debt-holders are paid off.

? Value of stock = Enterprise value of firm ? market value of debt.

? Second, we can directly consider the net cash available to be distributed to the shareholders ("free cash flow to equity"). We will begin the discussion using this second model.

Gordon Growth Model (1/3)

? The simplest stock valuation model ? the Gordon Growth Model ? values the stock by discounting dividends that are distributed to the shareholders. ? Note that this model cannot be applied to all firms without modification. ? This model is also called the Gordon Dividend Model.

Gordon Growth Model (2/3)

? Consider a firm that is in a stable business, is expected to experience steady growth, is not expected to change its financial policies (in particular, financial leverage), and that pays out all of its free cash flow as dividends to its equity holders.

? We can price such a stock as the present value of its expected dividends, assuming that the firm lives forever.

The Gordon Growth Model (3/3)

? With the additional assumption that the firm is expected to live forever, we can write the current stock price, P, as::

? P = D1/(k-g) ? D1 is the expected dividend in the next period

D1=D0 (1 + g) where D0 is the current year's dividend. ? G is the expected growth in dividends. ? k is the cost of equity. This is required rate of return required by shareholders for investing in the stock.

Assumptions Underlying the Gordon

Growth Model

? 1. Stable business: The assumption here is that the business model of the firm is stable. It is not expected to change its operations significantly as, for example, move into a different business.

? 2. Steady growth: We may assume that the firm (dividends, FCFE) will grow at a constant growth rate, g, year after year.

? 3. Stable financial leverage: A change in capital financial leverage would change the cost of equity capital. Stable business + Stable financial leverage => cost of equity capital, k, is constant.

? 4. Dividend and FCFE: All of the firm's free cash flow is paid out as dividends.

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