How to Determine Stock Prices in a Constant Growth Model

by Bryan Keythman

    The constant dividend growth model, or the Gordon growth model, is one of several techniques you can use to value a stock that pays dividends. Because a company can potentially exist without end, this model assumes that a stock will continue to grow its dividends at a constant rate forever. The price that the model generates is the most you could pay for the stock to earn your required return based on the estimated dividend growth rate. The model provides the most reliable results for mature companies with steady historical dividend and earnings growth.

    Step 1

    Visit a financial website that provides stock information, such as Yahoo Finance. Type a stock’s ticker symbol into the stock quote text box and click “Get Quote” to bring up its main quote page.

    Step 2

    Click “Dividend History” or a similar link to view the stock’s historical dividends. If there is no dividend history link, check the “Historical Prices” section for historical dividends.

    Step 3

    Identify the most recent dividend payment and one that occurred at least three years ago. For example, assume a stock paid a 50-cent quarterly dividend four years ago and 68 cents in its most recent quarter.

    Step 4

    Divide the most recent dividend by the older dividend. In this example, divide $0.68 by $0.50 to get $1.36.

    Step 5

    Divide 1 by the number of years between the two dividends. In this example, there are four years between the two dividends, so divide 1 by 4 to get 0.25.

    Step 6

    Type your Step 4 result into a calculator. Push the exponent key, which is usually designated by a caret “^” or an “x^y” symbol. Type your Step 5 result and push “Enter” or the equal sign. In this example, type “1.36” in your calculator, push the exponent key, type “0.25” and push “Enter” to get 1.08.

    Step 7

    Subtract 1 from your Step 6 result to determine the stock’s annual dividend growth rate. In this example, subtract 1 from 1.08 to get 0.08, or an 8 percent growth rate.

    Step 8

    Click the “Key Statistics” section of the financial website and identify the stock’s forward annual dividend rate, which is the total dividends the company is expected to pay over the next year. If a website does not report the forward rate, use the regular annual dividend rate instead. In this example, assume the stock will pay dividends of $2.72 over the next year.

    Step 9

    Decide the annual percentage return you would require to own the stock. This is typically the same return you could earn on a similar investment with the same risk, but it must be greater than the dividend growth rate in order to use the Gordon model. In this example, assume you require a 12 percent annual return.

    Step 10

    Subtract the dividend growth rate from your required return. In this example, subtract 0.08 from 0.12 to get 0.04.

    Step 11

    Divide next year’s expected dividend by your result to calculate the stock’s price. Concluding the example, divide $2.72 by 0.04 to get $68. This means you could pay up to $68 for this stock to earn your 12 percent required return.

    Items you will need

    • Calculator

    Tip

    • Use a different dividend growth rate in Step 10 than the one you calculated in Step 7 if you believe the company will grow faster or slower than it has in the past.
    • Because the constant growth model overlooks important factors, such as a company‚Äôs financial performance, use it only in combination with other methods when valuing a stock.

    About the Author

    Bryan Keythman has performed stock investment research and writing for a consulting firm since 2008. He also has prior experience sourcing and underwriting commercial real-estate investment and development opportunities for a commercial real-estate developer. Keythman holds a Bachelor of Science in finance.

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