Problems with the model

Problems with the model

a) The model requires one perpetual growth rate

• greater than (negative 1) and
• less than the cost of capital.

But for many growth stocks, the current growth rate can vary with the cost of capital significantly year by year. In this case this model should not be used.

b) If the stock does not currently pay a dividend, like many growth stocks, more general versions of the discounted dividend model must be used to value the stock. One common technique is to assume that the Miller-Modigliani hypothesis of dividend irrelevance is true, and therefore replace the stocks's dividend D with E earnings per share.

But this has the effect of double counting the earnings. The model's equation recognizes the trade off between paying dividends and the growth realized by reinvested earnings. It incorporates both factors. By replacing the (lack of) dividend with earnings, and multiplying by the growth from those earnings, you double count.

c) Gordon's model is sensitive if k is close to g. For example, if

• dividend = $1.00
• cost of capital = 8%

Say the

• growth rate = 1% - 2%

So the price of the stock

• assuming 1% growth= $14.43 = 1.00(1.01/.07)
• assuming 2% growth= $17.00 = 1.00(1.02/.06)

The difference determined in valuation is relatively small.

Now say the

• growth rate = 6% - 7%

So the price of the stock

• assuming 6% growth= $53 = 1.00(1.06/.02)
• assuming 7% growth= $107 = 1.00(1.07/.01)

The difference determined in valuation is large.