Gordons model

The dividends of most companies are expected to grow and evaluation of value of shares based on dividend growth is often used in valuation of shares. Dividend valuation model assumes a constant level of growth in div in perpetuity. The Gordon growth model is theoretical model used to value ordinary equity shares. The model incorporates the retention of earnings and growth of dividends and hence it is called as dividend growth valuation model. The main proposition of the model is that the value of shares reflects the value of future dividends accruing to that share. Hence, the dividend payments and its growth are relevant in valuation of shares. The model holds that shares market price is equal to the sum of shares discounted to the sum of shares discounted future dividend payments. Assumptions:Gordon growth valuation model using dividend capitalization is based on the following assumptions:1. The firm is an all equity firm and has no debt. 2. External financing is not used in the firm. Retained earnings represent the only source of financing. 3. The internal rate of return is the firms cost of capital k. it remains constant and is taken as the appropriate discount rate. 4. Future annual growth rate dividend is expected to be constant. 5. Growth rate of the firm is the product of retention ratio and its rate of return. 6. Cost of capital is always greater than the growth rate. 7. The company has perpetual life and the stream of earnings are perpetual. 8. The retention ratio b, once decided upon, remains constant. Therefore, the growth rate g = br is also constant forever. In valuation of share under Gordon growth model, the following formula is used:P0 = D0(1+g)/ke-g = D1/ke-g D0 = current years dividend.

The shareholders required rate of return (Ke) can also be calculated by using the capital asset pricing model. The model requires the estimation of future growth of dividends. The Gordon growth model using dividend capitalization can also be presented as follows:Criticism:the Gordon growth model is criticized for the following reasons:1. 2. 3. 4. In real world, the constant dividend growth and earnings growth is a fallacy. The model implies that if D0 is zero, the value of share is nil. The capital gains are ignored by the model. The false assumption is that investors will buy and hold the shares for an infinite period of time. 5. The model ignores the allowance for corporate and personal taxation. 6. The diminishing marginal efficiency of investment is ignored. 7. The effect of change in the firms risk class and its effect on firms cost of capital is ignored.