Calculating Stock Price

Stock Price Calculator (Gordon Growth Model)

Use this calculator to estimate the intrinsic value of a stock based on its future dividends, using the Gordon Growth Model (a form of the Dividend Discount Model).

function calculateStockPrice() { var currentDividendInput = document.getElementById("currentDividend").value; var dividendGrowthRateInput = document.getElementById("dividendGrowthRate").value; var requiredRateOfReturnInput = document.getElementById("requiredRateOfReturn").value; var currentDividend = parseFloat(currentDividendInput); var dividendGrowthRate = parseFloat(dividendGrowthRateInput) / 100; // Convert to decimal var requiredRateOfReturn = parseFloat(requiredRateOfReturnInput) / 100; // Convert to decimal var resultElement = document.getElementById("calculatedStockPrice"); if (isNaN(currentDividend) || isNaN(dividendGrowthRate) || isNaN(requiredRateOfReturn) || currentDividend < 0 || dividendGrowthRate < 0 || requiredRateOfReturn < 0) { resultElement.innerHTML = "Please enter valid positive numbers for all fields."; return; } if (requiredRateOfReturn <= dividendGrowthRate) { resultElement.innerHTML = "The Required Rate of Return must be greater than the Dividend Growth Rate for this model to be valid."; return; } // Calculate D1 (Expected dividend next year) var expectedDividendNextYear = currentDividend * (1 + dividendGrowthRate); // Calculate Stock Price using Gordon Growth Model var stockPrice = expectedDividendNextYear / (requiredRateOfReturn – dividendGrowthRate); resultElement.innerHTML = "$" + stockPrice.toFixed(2) + ""; }

Understanding the Gordon Growth Model for Stock Valuation

The Gordon Growth Model (GGM) is a popular method for valuing a stock based on the present value of its future dividends. It's a specific application of the Dividend Discount Model (DDM) and assumes that dividends grow at a constant rate indefinitely. While simplified, it provides a foundational understanding of how future cash flows (dividends) contribute to a stock's intrinsic value.

How the Gordon Growth Model Works

The core idea behind the GGM is that a stock's intrinsic value is the sum of all its future dividends, discounted back to their present value. The formula used is:

Stock Price = D1 / (r - g)

Where:

• D1: The expected dividend per share for the next year. This is calculated as the current annual dividend (D0) multiplied by (1 + the dividend growth rate).
• r: The investor's required rate of return (or cost of equity). This represents the minimum return an investor expects to earn for taking on the risk of owning the stock.
• g: The constant growth rate of dividends, assumed to continue indefinitely.

Inputs Explained:

1. Current Annual Dividend Per Share ($): This is the total dividend paid out per share over the last 12 months. You can usually find this information on financial websites or the company's investor relations page.
2. Expected Dividend Growth Rate (%): This is the anticipated rate at which the company's dividends will grow each year. This can be estimated based on historical growth rates, analyst forecasts, or the company's reinvestment rate and return on equity. It's crucial that this growth rate is sustainable in the long term.
3. Required Rate of Return (%): This is the minimum rate of return an investor expects to receive for investing in the stock, considering its risk. It's often estimated using models like the Capital Asset Pricing Model (CAPM) or by considering the risk-free rate plus a risk premium.

Interpreting the Results

The calculated stock price represents the intrinsic value of the stock according to the Gordon Growth Model. If the current market price of the stock is below this calculated value, the stock might be considered undervalued. Conversely, if the market price is above the calculated value, it might be overvalued.

Limitations of the Gordon Growth Model

While useful, the GGM has several important limitations:

• Constant Growth Rate: It assumes dividends grow at a constant rate forever, which is rarely the case in reality. Companies often experience varying growth rates over different periods.
• Growth Rate Less Than Required Return: The model breaks down if the dividend growth rate (g) is equal to or greater than the required rate of return (r). In such cases, the denominator (r – g) becomes zero or negative, leading to an infinite or negative stock price, which is illogical.
• No Dividends: It cannot be used for companies that do not pay dividends.
• Sensitivity to Inputs: Small changes in the growth rate or required rate of return can lead to significant changes in the calculated stock price.

Despite its limitations, the GGM serves as a valuable tool for understanding the relationship between dividends, growth, and required returns in stock valuation, especially for mature, dividend-paying companies with stable growth.

Example Calculation:

Let's say a company currently pays an annual dividend of $2.00 per share. You expect its dividends to grow at 5% per year indefinitely, and your required rate of return for this stock is 10%.

• Current Annual Dividend (D0) = $2.00
• Expected Dividend Growth Rate (g) = 5% (0.05)
• Required Rate of Return (r) = 10% (0.10)

First, calculate D1 (expected dividend next year):

D1 = D0 * (1 + g) = $2.00 * (1 + 0.05) = $2.00 * 1.05 = $2.10

Now, apply the Gordon Growth Model formula:

Stock Price = D1 / (r – g) = $2.10 / (0.10 – 0.05) = $2.10 / 0.05 = $42.00

Based on these inputs, the estimated intrinsic value of the stock is $42.00 per share.