Gordon Growth Dividend Model Assumptions and Criticism
Gordon Growth Dividend Model: The model states that the market value of a share is equal to the present value of an infinite stream of dividends received by the shareholders.
P = DIV1/(1+k) + DIV2/ (1+k)² + ……… + Σ DIVt/ (1+k) to the power ‘t’
Gordon Dividend Model was developed by Myron Gordon which relates the market value of the firm with that of its dividend policy. The dividend per share grows as the firm retained the earnings. One important point to note is that dividend per share is equal to the payout ratio. The model assumes that retained earnings are reinvested in the all equity firm at internal rate of return of r. This leads to grow in earnings. So when growth is also included with earnings and dividends, the market price of share is calculated as – IV
P = DIV (1+g)/ (1+k) + DIV (1+g)²/ (1+k)² + DIV (1+g)³/(1+k)³
Gordon Growth Dividend Model Assumptions
- No external financing: There is no external financing available. Companies retained earnings are used to finance the projects.
- All- equity firm: The firm is financed through equity capital and there in no debt financing.
- Returns are constant: The internal rate of return that is r of the firm is constant. This implies that it ignores the diminishing marginal efficiency.
- Cost of Capital is also constant: The discount rate (k) remains constant. This implies it completely ignores the effect due to change in firms risk class.
- Retention ratio is constant: The retention ratio (br) and the growth rate(g) is constant.
- The cost of capital is greater than growth rate: The discount rate is greater than the growth rate that is k>br=g.
Findings of Gordon Dividend Model
- The market value of the share increases with the increase in retention ratio.
- Dividend policy does not affect Market Value of share.
- With the increase in payout ratio, the market value of share also increases.
Gordon Growth Dividend Model Criticism
- No external Financing: The model assumes that company finances with retained earnings only. It does not look for external financing. However in reality a company go for a blend of internal as well as external financing.
- Constant return: Gordon’s model is based on the assumption that returns are constant. However in reality the situation is different. As the company increases the investment, the returns decreases.
- Cost of Capital is constant: The model assumes constant cost of capital. But in practicality as the firm increases to more risk the cost of capital also increases.