How can you use the Gordon growth model to estimate terminal value? (2024)

The Gordon growth model, also known as the constant growth model or the dividend discount model, is a formula that values a stock by discounting its expected future dividends. The formula is: Value = Dividend / (Discount rate - Growth rate) The dividend is the expected dividend payment in the next period, the discount rate is the required rate of return for the stock, and the growth rate is the constant annual growth rate of the dividend. The model assumes that the dividend grows at a constant rate forever, and that the discount rate is higher than the growth rate.

To use the Gordon growth model to estimate terminal value, you need to apply the formula to the cash flow stream that you are valuing. For example, if you are valuing a project that generates free cash flow (FCF), you can use the following formula: Terminal value = FCF / (WACC - Growth rate) The FCF is the expected free cash flow in the last forecast period, the WACC is the weighted average cost of capital for the project, and the growth rate is the constant annual growth rate of the FCF. The model assumes that the FCF grows at a constant rate forever, and that the WACC is higher than the growth rate.

The Gordon growth model is a simple and easy-to-use method to estimate terminal value, requiring only three inputs: cash flow, discount rate, and growth rate. Additionally, it is consistent with the concept of intrinsic value, as it reflects the present value of the future cash flows that the asset can generate. This model is widely accepted by practitioners and academics due to its basis on a well-known valuation model.

The Gordon growth model has some limitations when estimating terminal value. It is sensitive to the discount rate and growth rate assumptions, and small changes in these inputs can have a large impact on the terminal value. Additionally, it is unrealistic to assume that the cash flow will grow steadily forever, as businesses usually encounter changes in competition, technology, and regulations over time. Furthermore, this method may not be suitable for certain types of assets that don't pay dividends or have negative or volatile cash flows.

To improve the accuracy of the Gordon growth model, you can use various techniques to adjust the inputs or the formula. For instance, performing a sensitivity analysis with a range of discount rates and growth rates can help you test different scenarios. Additionally, using a multi-stage growth model that allows for different growth rates in different periods can be beneficial. Moreover, a residual income model that incorporates the book value and return on equity of the asset instead of relying solely on cash flow can also be helpful.

This is a space to share examples, stories, or insights that don’t fit into any of the previous sections. What else would you like to add?

Financial Management

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