Example

Answer:

You can use the Gordon model in three steps--

• Calculate the growth rate
• Choose a discount rate (greater than the growth rate)
• Apply the Gordon model

What is the company's growth rate?

This is not obvious and requires a judgment call. Do we predict that growth will continue at the average annual growth rate for the last 6 periods? To compute this we could find the average growth rate. Or do we predict that growth will continue at the overall rate of the last seven years? To compute this we would find the internal growth rate over the 6 years of growth, in which the dividend went from 1.00 to 1.59.

The internal rate of return can be determined by using the present value formula and calculating the interest rate. This means i = (FV/PV)^(1/n) -1.

Usually, business valuators use the internal rate of growth, since it reflects the growth rate over a period better than an average. In effect, it gives you an idea of the internal "growth machine" of the business.

What is the required return (discount rate) for Company's stock?

This is even trickier. One method is to use the CAPM -- which predicts the company's expected return (required return or discount rate) based on the stock's expected volatility and the market's expected return. For now, let's assume the discount rate is 14.0%.

As we saw before in computing value under different capitalization rate assumptions, the discount rate will be one of the most important (and hotly contested) issues in a valuation.

Apply the Gordon model.

Notice that the formula requires that you compute the return in the first period of growth [D_o(1 +g) = $ 1.72] and then divide this by the difference of the discount rate and the growth rate [.14 - .0815 = .0585].