The Gordon Growth model is an offshoot of the standard dividend discount model. This model is used primarily to calculate the intrinsic value of a firm based on the discounted value of future dividends.
At a basic level the Gordon Growth Model is calculated by:
P = D1 / r-g
- P = The intrinsic price you should pay for the firm
- D1 = The dividend for the next period
- R = The current discount rate, for our purposes we will use the CAPM for this
- G = Is the dividend growth rate
Applying the Gordon Growth ModelSo, we know how this is calculated if you are doing this on a sheet of paper, and if you don’t have the data there may be some pieces of information that you need to assume. However, what if we could get rid of those assumptions as well as run this analysis on more than just one company at a time? What if we could run this against the entire market all at once?
In Equities Lab we have run a screener with the only parameter being true. We then plotted the Gordon Growth Model and can now see the intrinsic value of all stocks within the universe. Now, there is one major downside to this model and that it only works with companies that have a dividend. Without a history of dividends, or at least a current dividend, we are unable to figure out future cash flows to you as an investor – resulting in an intrinsic value of 0. These companies are of course not worth zero, but we will need to use a different model in order to come up with their values; which is something we will do in a later article.
So, how do we calculate the Growth Model in the Equities Lab system? Well, for you as a user you can simply create a new tab in any screener and “import Gordon Growth Model”, but for a solid calculation let’s explore the formula.
In our system we don’t make estimations. However, we can extrapolate how much the next period’s dividend is going to be by using entirely historic data. To find next the dividend payment for next dividend we just multiply this periods dividend by a growth rate we calculate. For the most accurate rate we take the average change of the dividend per share for the last 5 periods, divide that number by 100 and add 1 to that number.
Now that we have the dividend for the next period we need to calculate the CAPM. This is already done in the system and we talk about the CAPM calculation in our CAPM article which I have linked here. The standard equation doesn’t call for the absolute value of the CAPM, but we have found that it helps the general strategy generate more alpha over time if you take the absolute value.
Everything is finally calculated and that’s all fine and dandy, but can this model actually be used to generate returns? If not, why is it being taught is school.
To test this we just need a simple, one-line screener. In essence we want to purchase all companies that seem to be priced lower than what their Gordon Growth Model suggests.
It appears that there are just about 380 companies in our universe that are underpriced according to this model. What happens when we backtest this?
From the year 2000, this strategy does incredibly well by generating roughly 13% annual returns and having a monthly sharpe ratio of 0.1564 compared to the S&P 500’s return of 5.4% and a sharpe of 0.1086.
However, it previous articles we’ve found that it’s fairly easy to beat the market over this time frame. What is more difficult is taking a strategy that looks for mispricing, like this one, and use it to beat the more in more recent times.
Since the end of the great recession this strategy has outperformed the market by a pretty significant margin. Now, this does fall apart when you eliminate 2009 from the running and the same tale of valuepocalypse takes effect.
That all said you can still generate some pretty decent returns with a screen that is only one line.
At the end of the day the Gordon Growth Model and the accompanying dividend discount models are incredibly important in the valuation process of a company. There is a reason it is one of the methods taught in virtually every financial valuation course in Universities. It’s simple, effective, and really helps students understand the part cash flows play when it comes to making an informed investment decision.