Constant Growth Stocks
by MaestriEquation 5-1 is a generalized stock valuation model in the sense that the time pattern of Dt can be anything: Dt can be rising, falling, fluctuating randomly, or it can even be zero for several years, and Equation 5-1 will still hold. With a computer spreadsheet we can easily use this equation to find a stock’s intrinsic value for any pattern of dividends.
In practice, the hard part is getting an accurate forecast of the future dividends. However, in many cases, the stream of dividends is expected to grow at a constant rate. If this is the case, Equation 5-1 may be rewritten as follows:8The last term of Equation 5-2 is called the constant growth model, or the Gordon model after Myron J. Gordon, who did much to develop and popularize it.
Note that a necessary condition for the derivation of Equation 5-2 is that rs be greater than g. Look back at the second form of Equation 5-2. If g is larger than rs, then (1 g)t/(1 rs)t must always be greater than one. In this case, the second line of Equation 5-2 is the sum of an infinite number of terms, with each term being a number larger than one. Therefore, if the constant g were greater than rs, the resulting stock price would be infinite! Since no company is worth an infinite price, it is impossible to have a constant growth rate that is greater than rs. So, if you try to use the constant growth model in a situation where g is greater than rs, you will violate laws of economics and mathematics, and your results will be both wrong and meaningless.
Taken From : Five-Minute MBA – Corporate Finance
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