Gordon Model

Strategic Corporate Finance
Presented by:
SHEETAL A. JAIMALANI(52) SHRIJESH K. GOVINDAN(55) KSHITIJ TIWARI(26) NEHA RAWAL(34)
Dividend Theories
Relevance Theories
(i.e. which consider dividend decision to be relevant as it affects the value of the firm)
Irrelevance Theories
(i.e. which consider dividend decision to be irrelevant as it does not affects the value of the firm)
Walters Model
Gordons Model
Modigliani and Millers Model
GORDON MODEL
According to Prof. Gordon, Dividend Policy almost always affects the value of the firm. He Showed how dividend policy can be used to maximize the wealth of the shareholders. The main proposition of the model is that the value of a share reflects the value of the future dividends accruing to that share. Hence, the dividend payment and its growth are relevant in valuation of shares. The model holds that the shares market price is equal to the sum of shares discounted future dividend payment.
Definition
A model for determining the intrinsic value of a stock, based on a future series of dividends that grow at a constant rate. Given a dividend per share that is payable in one year, and the assumption that 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 simplistically assumes a constant growth rate, it is generally only used for mature companies (or broad market indices) with low to moderate growth rates.
Assumptions of the model:

The firm is an all equity firm. No external financing is used and investment programmes are financed exclusively by retained earnings. Return on investment( r ) and Cost of equity(Ke) are constant. The firm has perpetual life. The retention ratio, once decided upon, is constant. Thus, the growth rate, (g = br) is also constant. Ke > br
Arguments of this model:

Dividend policy of the firm is relevant and that investors put a positive premium on current incomes/dividends. This model assumes that investors are risk averse and they put a premium on a certain return and discount uncertain returns. Investors are rational and want to avoid risk. The rational investors can reasonably be expected to prefer current dividend. They would discount future dividends. The retained earnings are evaluated by the investors as a risky promise. In case the earnings are retained, the market price of the shares would be adversely affected. Investors would be inclined to pay a higher price for shares on which current dividends are paid and they would discount the value of shares of a firm which postpones dividends. The omission of dividends or payment of low dividends would lower the value of the shares.
According to Gordon, the market value of a share is equal to the present value of the future streams of dividends.
E(1 - b) P= Ke - br
Where:
P E b
= Price of a share = Earnings per share = Retention ratio
1-b
Ke
= Dividend payout ratio

= Cost of capital or the capitalization rate
br (or)g = Growth rate
D/P Ratio Retention Ratio Cost of capital r EPS
Case A 40 60 17% 12% $20
Case B 30 70 18% 12% $20 => => $81.63 (Case A) $62.50 (Case B)
$20 (1 - 0.60) P = 0.17 (0.60 x 0.12) $20 (1 - 0.70) P = 0.18 (0.70 x 0.12)
Real Estate Bubble

Gordons growth model to calculate the value of a sample house. Apartment Size: 1800 Sq ft Rent Per month in that location: Rs. 19,000 Rental Advance: 10 times or Rs. 190,000 Assuming an increase of 15% rental every year, and an Inflation Rate of 10%, the value of the apartment is Rs. 41,80,000. Present value of Interest earned on Rs 190,000 in perpetuity at 15% is Rs 5,70,000. Total Value of the house is Approximately Rs. 47,50,000. The current price of the apartment is Rs. 80,00,000 (approximately). So Gordon model is used here to show that the house is overpriced.
Pepsi
Pepsi yields approximately 3.30% with a current annual dividend of approximately $2 a share. Over the long term, no company can grow faster than the gross domestic product. The long-term average growth in the gross domestic product of the United States, which is 3%. The cost of equity is 6%. Using Gordons growth model, Pepsis stock has a valuation of $69 a share.
CitiGroup
With these factors in mind, we will assume that Citigroup is in stable growth, and that its current earnings (estimated for 2000) of $ 13.993 billion will grow 5% in perpetuity. In addition, we will assume that the payout ratio looking forward will be 56.40% (the average modified payout ratio over last 4 years) and that the beta for the stock based upon its business mix is 1.00. With these inputs, a risk free rate of 5.1% and a risk premium of 4%.
Cost of equity for Citigroup = 5.1% + 1.00 (4%) = 9.1% Value of Citigroups equity = $13.993 (1.05) (.564)/(.091-.05) = $202.113 billion
Canara Bank
EPS 75.68
Divident
Ke
110% 75.68* 1.1= 83.248 16.72% 5%
83.248 0.1672 0.05 =>
Rs. 710.3
Canara Bank
Stock price calculated from the Gordon growth model is 710.30
The current market price for 52 week is 667.90 which can reach 710.3 if the current dividend growth of 5% is continued.
Thank You

Gordon Model

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Gordon Model

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Strategic Corporate Finance

Modigliani and Millers Model

Assumptions of the model:

Arguments of this model:

= Price of a share = Earnings per share = Retention ratio

= Dividend payout ratio

br (or)g = Growth rate

D/P Ratio Retention Ratio Cost of capital r EPS

Case A 40 60 17% 12% $20

Real Estate Bubble

110% 75.68* 1.1= 83.248 16.72% 5%

83.248 0.1672 0.05 =>

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