Gordon’s Growth Model and its application to Hospitality Field

By Ratko Jankovic / Finance and Strategy Lecturer at SWISS IM&H in Weggis, Switzerland

Considering a fact that I am currently, at my International Financial Risk Management Course, covering Gordon’s Growth (also known as “Dividend Discount”) Model, I take a bit of time to shed some light on this excellent piece of Financial Theory and shed some light on various legal structures (C-Corporations vs. REITs).

The Gordon Growth Model — otherwise described as the dividend discount model — is a stock valuation method that calculates a stock’s intrinsic value.

In order to value a share, you need an estimate for next year’s expected dividend per share, the long-run expected growth rate of dividends, and also the investor’s required return. Once you have these, the model says that the price of a particular share should be next year’s expected dividend per share, divided by the investor’s required return, less the long-term dividend growth rate.

The Gordon Growth Model assumes the following conditions:

  • The company’s business model is stable; i.e. there are no significant changes in its operations
  • The company grows at a constant, unchanging rate
  • The company has stable financial leverage
  • The company’s free cash flow is paid as dividends

Gordon’s Growth Model — Variables

Three variables are included in the Gordon Growth Model formula: (1) D1 or the expected annual dividend per share for the following year, (2) k or the required rate of return, and (3) g or the expected dividend growth rate. With these variables, the value of the stock can be computed as:

Intrinsic Value = D1 / (k — g)

To illustrate, take a look at the following example: Company A’s is listed at $40 per share. Furthermore, Company A requires a rate of return of 10%. Currently, Company A pays dividends of $2 per share for the following year which investors expect to grow 4% annually. Thus, the stock value can be computed:

Intrinsic Value = 2 / (0.1–0.04)

Intrinsic Value = $33.33

This result indicates that Company A’s stock is overvalued since the model suggests that the stock is only worth $33.33 per share.

Limitations

The assumption that a company grows at a constant rate is a major problem with the Gordon Growth Model. In reality, it is highly unlikely that companies will have their dividends increase at a constant rate. Another issue is the high sensitivity of the model to the growth rate and discount factor used.

The model can result in a negative value if the required rate of return is smaller than the growth rate. Moreover, the value per share approaches infinity if the required rate of return and growth rate have the same value, which is conceptually unsound.

Furthermore, since the model excludes other market conditions such as non-dividend factors, stocks are likely to be undervalued despite a company’s brand and steady growth.

At SWISS IM&H, I have used Gordon’s Growth Model in my Financial Management class. I have showed my students how Gordon’s Growth Model can be used to value a specific stock, and students seem to think that this model is simple and easy to use for stock’s valuation, despite its “obvious” limitations described above.

Nevertheless, what is important to “keep in mind” when valuing a specific, in this case, company operating in Hospitality (Hotel, for instance) is to make sure that a company pays a dividend. Only then, Gordon’s Growth Model can be used to value a company’s stock, now, keeping in mind that Hotel Industry is “split” into two main categories of companies, it is thus important to know to which of the two (C-Corporations of REITs) a specific Hotel belongs, as based on that, an analyst can engage in “determining” share prices (of specific company/hotel), since REITs’ and C-Corps’ dividends are not taxed at the same rate. In fact, REITs, due to their legal structure, are not obliged to pay tax on the dividends they distribute, which greatly affects value of these types of firms, while C-Corps must pay corporate taxes on their dividends, which has effect on their stock prices, of course, but this will be discussed in greater detail in some of my future articles published on this topic!

References:

1) Corporate Finance Institute/Gordon’s Growth Model
2) Investopedia:
https://www.investopedia.com/top-hotel-stocks-5078914
3) Moneyweek (Moneyweek.com)

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