Fam Wencong, Kenneth

My Diary

How To Value Stocks

Published: Saturday, May 16, 2020

Investors who want to sport market-beating returns must put in a little weekend homework. Arguably, the single most important skill investors can learn is how to value a stock. Without this proficiency, investors are left dancing in the market’s winds without a firm foundation, not knowing if a company’s future growth projections are already baked into the stock price or if a company’s shares are severely undervalued.

Today, I will discuss the method I use to value stocks.

The Gordon Growth Model.

What Is The Gordon Growth Model?

The Gordon Growth Model (GGM) is used to determine the intrinsic value of a stock based on a future series of dividends that grow at a constant rate. It is a popular variant of the discounted cash flow model.

Given a dividend per share that is payable in one year and the assumption the dividend grows at a constant rate in perpetuity, the model solves for the present value of the infinite series of future dividends. Because the model assumes a constant growth rate, it is generally only used for companies with stable growth rates in dividends per share.

The Formula for the Gordon Growth Model Is:

​where:

  • P = Stock price valuation
  • g = Constant growth rate expected for dividends, in perpetuity
  • r = Constant cost of equity capital for the company (or rate of return)
  • D1 = Value of next year’s dividends​

Personally, I find finding r hard as there are multiple ways of finding the rate of return. Such methods include the Internal Rate of Return (IRR), Capital Asset Pricing Model (CAPM) and etc.

I just use the historical rate of return on the S&P500.

Example Using The Gordon Growth Model

As a hypothetical example, consider a company whose stock is trading at $110 per share. This company has an r of 8% and currently pays a $3 dividend per share, which is expected to increase by 5% annually (g).

The intrinsic value (P) of the stock is calculated as follows:

  • P = $3 / [.08 – .05]
  • P = $100

According to the Gordon Growth Model, the shares are currently $10 overvalued in the market.

What If The Stock Does Not Pay A Dividend?

If you want to value a stock that does not pay a dividend, you can use other methods such as the discounted cash flow model. Or you can also decide to make it easy for yourself and apply the Gorden Growth model on earnings.