For the most part, investments are educated guesses over time. If you guess correctly, you can cash in big time, but if your guess is wrong, you can lose your money.
But how do you know if your guess is correct? Well, you don’t, but there are factors you can take into account before you invest your hard-earned money in a business.
This is where my constant growth rate model calculator comes in handy. Essentially, it tells you the current fair price of the stock to be to hit your investment targets.
Constant Growth Model Definition
The constant growth model, often known as the Gordon Growth Model, is used in finance to compute the present value of an infinite series of future dividends expected to grow constantly.
Investors use this model to estimate a stock’s fair value by considering the expected dividend per share, the dividend growth rate, and the required rate of return.
Applicability in Investment Decisions
Using this model provides an objective basis for analysts to determine if a stock is undervalued or overvalued.
This can guide you in making more informed decisions.
While the model works best for companies with a stable dividend growth rate, its accuracy decreases for those with irregular dividends.
You should be cautious when applying it to businesses in volatile industries.
When used wisely, the constant growth model provides a foundation for evaluating stock investments. It is a reliable method for estimating the future value of companies with a consistent payout history.
Constant Growth Model Formula
To calculate the constant growth model, you’re going to use the Gordon growth model formula:
CP = ED / (R - G)Where:
- CP: Current stock price
- ED: Expected dividend
- R: Required rate of return
- G: Expected growth rate of dividends
This formula helps you determine the present value of anticipated future dividends.
It stresses the relationship between dividend growth and stock valuations.
As the growth rate approaches the required rate of return, the model produces a more sensitive and higher stock valuation.
Constant Growth Model Example Calculation
To illustrate how the constant growth model works, consider a stock with:
- Expected dividend next year: $2.00
- Required rate of return: 8%
- Dividend growth rate: 4%
Plugging these values into the formula gives:
CP = $2.00 / (0.08 - 0.04) = $50Thus, the fair value of the stock is $50.