Intrinsic Value Calculator (Gordon Growth Model)
Understanding Intrinsic Value and the Gordon Growth Model
In the world of investing, determining the true worth of an asset, particularly a stock, is paramount. This "true worth" is often referred to as its intrinsic value. Unlike market price, which can fluctuate based on supply, demand, and investor sentiment, intrinsic value aims to represent the fundamental, underlying value of a company based on its financial health and future prospects.
What is Intrinsic Value?
Intrinsic value is an analytical estimate of a company's worth, independent of its current market price. It's what an asset is truly worth, based on a thorough analysis of its financial statements, business model, competitive landscape, and future cash flow potential. Investors often compare a stock's intrinsic value to its market price to identify potential investment opportunities: if the intrinsic value is higher than the market price, the stock might be undervalued; if it's lower, it might be overvalued.
The Gordon Growth Model (GGM)
One popular method for estimating intrinsic value, especially for dividend-paying stocks, is the Gordon Growth Model (GGM), also known as the Dividend Discount Model (DDM) with constant growth. Developed by Myron J. Gordon, this model calculates the intrinsic value of a stock based on the present value of its future dividends, assuming those dividends grow at a constant rate indefinitely.
The formula for the Gordon Growth Model is:
Intrinsic Value = D1 / (r - g)
Where:
- D1 = Expected Dividend Per Share for the next period (Current Dividend * (1 + Growth Rate))
- r = Required Rate of Return (or Cost of Equity)
- g = Expected Dividend Growth Rate (constant)
Components of the Calculator:
Our Intrinsic Value Calculator uses the Gordon Growth Model and requires three key inputs:
-
Current Dividend Per Share ($):
This is the most recent dividend paid out by the company per share. It serves as the starting point for projecting future dividends. For example, if a company paid $1.50 per share last year, this is your current dividend.
-
Expected Dividend Growth Rate (%):
This is the constant rate at which you expect the company's dividends to grow each year into the foreseeable future. This rate can be estimated based on historical dividend growth, industry averages, or analyst forecasts. A common range might be 3% to 7% for mature companies.
-
Required Rate of Return (%):
Also known as the cost of equity, this is the minimum rate of return an investor expects to receive for taking on the risk of investing in the company. It reflects the opportunity cost of investing elsewhere and the risk associated with the specific stock. This rate is often derived using models like the Capital Asset Pricing Model (CAPM) or by considering the risk-free rate plus a risk premium. Typical values might range from 8% to 12%.
How to Use the Calculator:
- Enter the Current Dividend Per Share (e.g., 1.50).
- Input your estimated Expected Dividend Growth Rate as a percentage (e.g., 5 for 5%).
- Enter your desired Required Rate of Return as a percentage (e.g., 10 for 10%).
- Click "Calculate Intrinsic Value" to see the estimated intrinsic value per share.
Example Calculation:
Let's say a company paid a current dividend of $1.50 per share. You expect its dividends to grow at a constant rate of 5% per year, and your required rate of return for this investment is 10%.
- Current Dividend (D0) = $1.50
- Expected Dividend Growth Rate (g) = 5% (0.05)
- Required Rate of Return (r) = 10% (0.10)
First, calculate D1 (next year's dividend):
D1 = D0 * (1 + g) = $1.50 * (1 + 0.05) = $1.50 * 1.05 = $1.575
Now, apply the GGM formula:
Intrinsic Value = D1 / (r – g) = $1.575 / (0.10 – 0.05) = $1.575 / 0.05 = $31.50
According to the Gordon Growth Model, the intrinsic value of this stock would be $31.50 per share.
Assumptions and Limitations of the GGM:
While useful, the Gordon Growth Model relies on several critical assumptions:
- Constant Dividend Growth: It assumes dividends grow at a constant rate indefinitely, which is rarely the case for real-world companies.
- Required Rate of Return > Growth Rate: The model breaks down if the growth rate is equal to or greater than the required rate of return, leading to an infinite or negative intrinsic value. This is a mathematical necessity for the formula to work.
- Dividend-Paying Company: It's only applicable to companies that currently pay dividends and are expected to continue doing so.
- Sensitivity to Inputs: Small changes in the growth rate or required rate of return can lead to significant changes in the calculated intrinsic value.
Despite its limitations, the GGM provides a straightforward framework for valuing stable, mature, dividend-paying companies and serves as a good starting point for more complex valuation analyses.