The Constant Growth Approximation to Stock Valuation

The Gordon Growth Model for stock valuation is commonly called the constant growth approximation. It is a simple formula to estimate the current value of a stock based on potential future payoffs. In this sense, value is not to be confused with price. The price of a stock is simply what a buyer is willing to pay for it, and therefore the price set by the market. The value can be higher or lower than the price, depending on whether the market consideration of value is accurate.

Undervalued Stock

Every investor is looking for undervalued stock. When a stock is priced lower than you believe its actual value to be, you will buy the stock. The same is true of any investment, such as a home or a piece of art. You would like to purchase the investment for less than it is worth to capitalize on a return when you sell. If everyone valued stock according to the same method, no stock would be undervalued or under priced. A seller would hold onto the stock until a higher price offer came along.

Overvalued Stock

It is possible for a piece of stock to be overvalued. This means the going price is higher than the value of the underlying asset. This occurs at a high rate when an industry or stock is in a "bubble." Simply put, a bubble means the price of a stock is falsely inflated because advisers, analysts or investors believe its value to be higher than it actually is. Buying overvalued stock is an investor's nightmare. When a stock is priced too high, eventually it will drop in price to compensate for the discrepancy, and this drop can even cause it to become undervalued. This would represent a huge loss to the investor.

Using the Constant Growth Approximation Model

There are a number of different formulas and models analysts use to determine the value of a stock. One option is the constant growth approximation model. In this model, an analyst operates on the assumption the dividend per share of a stock will grow at a constant rate over time. The stock value is equal to the dividend divided by the difference between the required rate of return for the investor and the growth rate in dividends. This is expressed in the formula:

Value = D (dividend) / k (required rate of return) - G (constant growth)

Problems with the Constant Growth Approximation Model

This model only works if the underlying assumption that a dividend will grow at a constant rate is true. If this assumption is not true for a given asset, then the model will fail to accurately value a stock. It is very difficult to estimate the constant rate of growth on a new stock or highly volatile stock; in fact, the rate will not typically be constant in this case. Therefore, the model is best used for corporate stocks that have been in existence for a significant period of time and have produced constant growth dividends in the past.