Gordon growth Model

[FrancescoCCC]

I came across the Gordon Growth model and, for curiosity, I tried to calculate the value of a stock.

According to Damodoran:
Value of Equity= Dividends per share * (1 + Expected Growth Rate in Earnings and Dividends)/(Cost of Equity - Expected Growth Rate in Earnings and Dividends)

For this example, I take into consideration ED (Corporate Edison).
ROE = 8%
EPS = 3.8$
Dividends Pay-ratio: 0.72
Dividends per share = EPS*Dividends Pay-ratio = 3.8*0.78 = 4.8
Expected Growth Rate in Earnings and Dividends: ROE*(1-payout) = 8*0.28 = 2.24
Cost of equity:4.02
Value of Equity = 4.8 * (1 + 0.028)/ (0.042 - .028) = 412
The value I get is completely out of any logic. I suppose there is an error (DPS seems off).


The nice thing is that, even when I use his (Damodaran) excel sheet (in Attachment) to calculate the value of equity all is a real mess... and I get strange values!

 

[SD_]

Please check the calculations below:

Calculating D1
= D0 * (1 + g) = EPS0 * (Payout ratio) * (1+g)
= 3.8 * 0.72 * [1+ ((ROE) * (1 - Payout ratio))]
= 3.8 * 0.72 * [1 + (0.08 * 0.28)]
= $ 2.7973

Calculating D1 / (Ke - g)
= 2.7973 * 100 / (4.02 - (8 * 0.28))
= $ 157.1517

This model assumes the following:
- ROE and Payout ratio will remain constant
- of course, the company will never go bankrupt (Going concern), therefore we derive the formula using an infinite sum of a GP

 

[FrancescoCCC]

Thank a lot.
However, ED is trading 60$ today...why the value you got is so high?

best regards

 

[SD_]

These valuations are never accurate because of the assumptions mentioned above.
During an M&A transaction, there are 4 basic ways to value a company, Gordon Growth being the least realistic IMO and the highly dependent on the assumptions like ROE and dividend growth rates. The selling company would value itself using the method which generates maximum sale value and the opposite for the buying company, that is where the middle-men (banks) come into the picture. The senior people do the talking and negotiate a price during these M&As.

Do you think that a company can have an ROE of 8% forever?

This is kinda like BSM, you use it to understand basic option valuations, but you can never use it to do the options market making in the real world.

 

[FrancescoCCC]

Thank you!

 

[SD_]

Thank you!

There was an error in my calculation please check if it is accurate now. However, the final valuation is still higher than the current price of $ 92.8 /share.

 

[FrancescoCCC]

What error?

 

[SD_]

I have edited the calculations, it was >300$ before.