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Many a times referred as the Gordon Growth Model , a lot of people find it difficult to understand the applications of this model . This brief tutorial examines how to understand and use this model and its reliability as a tool in making long term investment decisions . A long term Discounted Cash Flow Model, if understood well, can serve as a boon for long term investor . However, it is a bit confusing with its terms and terminology that sound simple but are harder to understand and apply in real life circumstances.
Discounted Cash Flow Model = EPS , Dividend , Cashflows / ( Investors Expected Rate of Return - Expected Growth Rate of the Company )
Now in the numerator what we see are different variables ranging from EPS,dividends and Cashflows. The usage of such depends on an investors preference , and whatever he thinks would be the right estimate in analyzing a company . For this example, we use EPS as an estimate . Expected Return is the return an investor wishes to earn onto his investment , and is indifferent to the stock he or she picks. It is an objective return as stated by the investor , whereas the growth rate is the expected rate of increase in a company's earnings or cashflow ( Usually Cashflow refers to Owners Earnings which is cash generated from regular operating activities and left after Capital Expenditures ) .
If cashflow is used in the numerator , its advisable to look at the growth rate in Cashflow so that we are comparing apples to apples , and oranges to oranges , And the same goes for EPS , or Dividends .
Let us simplify and put the formula then finally : EPS / ( R- g)
Now for our example we look at Gillette Company listed in India .As we all know Gillette is the biggest shaving and facial care industry in the world , with a dominant monopoly in the Indian Market.
A large base of loyal customers , and a price dominance within the industry .
A large base of loyal customers , and a price dominance within the industry .
Investor expects a 20 % return onto the stock in the long run , and the growth rate in earnings over the past 5 years has been 14.71 which we expect to continue in the future . EPS for the most recent year is 42 . Usually it is advisable to take EPS1 , that usually is the next years earnings while computing the formula , but just to be on a more safer and a conservative side we shall use EPS0 , the present years earnings .
Now let us do the calculation : 42/ (0.20 - 0.1471) = Rs. 793.95
The stock is trading at 1875 right now , which certainly is way above the valuations we have for it right at the moment . But a closer look states that the stock was just trading around the 600 level in the past two years . In such instances it was a really good buy , for a really long term and time .
Let us examine it in a different way , assuming we bought the stock at the 600-700 level certainly way below our estimates and kept it for a good 30-40 years in the portfolio before we actually need it ( it isn't called long term just for the sake of it) , how much would it have grown by ? We assume the price for which we bought the stock is 793.95
Now using the FV = PV ( 1+R)^n ( Assuming R = 20 % )
For 30 Years : 188,464.92 / 237.38 ( for every Rupee )
For 40 Years : 1,166,925.14/ 1469.77 ( for every Rupee )
Now certainly that is a good return for every 793.95 in the stock . We assume the stock can maintain the level of growth and return on the networth over the term of 30-40 years .
Stocks that usually work the best for this kind of assumption are Companies that sell premium products, have monoply or a moat that is hard or is impossible to penetrate . Has a competitive advantage which can be preserved under many cases , and circumstances and against most of the companies . Hard to get in .
Nonetheless the model we have used has some limitations :
1) We assume EPS here , and we assume all the dividends is invested into the business , if most of it is given back to investors in terms of dividends , it turns out to be the responsibility of the investor to find an investment that returns 20 percent on it , and grows at 14 percent . A difficult task to do for 30-40 years .
2) As the whole formula is based on assumptions a decrease in growth rate can have sudden impact onto the stocks valuations . It is always advisable to buy stocks trading at deep discount to what the valuations may say , so that any error in judgment won't result into big losses onto the investment .
As they say medicines are useful , but do have a side-effect . So before using any formula or a valuation technique understands its uses and limitations to discount for any errors that might arise into the future .
Anyhow , hope the session was informational , and we shall see and post more of it here . Keep posted .
