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One of the keys to getting a great margin of safety is to understand that price and value is not the same thing. That’s the whole secret to great investing.īuffett’s teacher Ben Graham, who wrote the Intelligent Investor, which is one of the best books on investing I’ve ever read said, “Buy stocks the way you buy groceries, not perfume.” That means to buy $10 dollar bills for $5 dollars. That means pay less than what it’s worth. Warren Buffett said, “The three most important words in investing are margin of safety.” That means to buy stuff on sale. D1.Margin of Safety: The Three Most Important Words in Investing We need to use the value of the second dividend that is paid in the terminal period i.e. For our purpose, that should be considered D0. However, it cannot be equal to or greater than r.Īlso, not that we did not take the first value from the terminal period i.e. g could even be a negative number implying that dividends are declining at a steady rate. Hence, r always has to be greater than g. r is greater than the constant growth rate that is assumed by the investor i.e. The Gordon model only works if the rate of return expected by the investors i.e.

Therefore, the terminal value for the above stock is $550 Important Point to Note:

The Gordon Growth Formula:Īccording to the Gordon growth model, the value of the stock is derived from two parts: Hence, instead of assuming that they will stop growing instantly we can assume that they will grow at a given constant rate till eternity. This assumption is obviously more viable given the fact that dividends do actually grow year on year. It then calculates the terminal value as a growing perpetuity instead of it being an ordinary perpetuity. So, if this rate was 10%, then the dividend for the 7th year will be $11 and that of the 8th year will be $12.21. However, instead of assuming that the dividend from 6th year onwards will remain constant at $10, the Gordon growth model assumes that the dividend will keep on increasing at a constant rate. This is the part where both the models remain the same. In this case too, we will assume that the firm pays 4, $5, $6, $7 and $8 in each of the 5 years of the horizon period. Calculation under Dividend Discount Model using Gordon Growth Rate: This means that the dividends being forecasted are constant. The normal dividend discount model will assume that the firm will continue paying, let’s say $10 dividend from the 6th year to perpetuity. Let’s assume that the firm will pay dividends of $4, $5, $6, $7 and $8 in each of the 5 years of the horizon period. Calculation under Dividend Discount Model: Beyond that he will consider the stock to be perpetuity. He selects a 5 year horizon period for which he will project the most accurate possible dividend projections. He is using the dividend discount model to do so. Let’s say that an analyst wants to forecast the value of a given stock. Let us understand this with the help of an example. The Gordon growth model simply assumes that the dividends of a stock keep of increasing forever at a given constant rate. This is where the Gordon growth formula becomes important. This part remains the same when the calculation is done as per Gordon Growth model as well. the period chosen by the analyst for which they believe they can accurately forecast the financials of the company and therefore its dividends. In the previous article, we became aware that the value of a stock can be split into two parts.