Tag: intrinsic value

  • Gordon Growth Model – Mathematics of Trading

    Gordon Growth Model – Mathematics of Trading

    5 min read

    Gordon Growth Model

    by Gorica Gligorijevic

    The Gordon Growth Model is useful to determine the intrinsic value of a stock and you will see how. It is all math.
    Anyone who wants to be a profitable trader has to know math. Profitable trading is not about feelings, or prophecy and stock advice or picks. It is all about math. Yes, the main goal is to earn money more than lose.

    But trading guessing is not a good idea. The math generates success and luck in your trading. Do you want to know how the math works in your attempts to profit and be a successful trader?

    If you want to act like a pro you have to be able to explain and make the math behind your trading. Anyway, you might benefit from understanding the math behind the stock market.

    At least, you have to know the basic calculations. 

    Traders-paradise wants to show you some simple to understand. It will help you to pick the right stock and keep your hopes of future returns more realistic.

    Let’s first determine the intrinsic value of stocks. How to do that? Just use of the Gordon Growth Model. Oh, yes. You will need more explanation.

    The Gordon Growth Model is known as the dividend discount model or DDM but without the current market stipulations, meaning the factors that influence the market, such as competitors, business challenges, etc.

    The point of this Gordon Growth model is to relate the current intrinsic value of stocks to the value of a stock’s future dividends. This is a very old model but still actual and popular. The equation shows that the long-term real return from the market should be almost equal to the inflation, modified by the compound yearly growth rate in dividends and increased by the current dividend yield. 

    Let’s view this complex definition in a simple example.

    The S&P 500 real growth rate in dividends has been around 1.3% per year over almost a hundred years. At the same period, the dividend yield was 5% annual. What you have to do is to sum these both. The sum you get is a bit less than actual 6,5% compound annual return from stocks for that period.

    This is defined by an almost doubling of the PE ratio, called a speculative return. That was exactly what did add the stock returns.

    Let’s see Gordon Growth Model and how to calculate it.

    As we said the value of a stock is shown as 

    Stock’s value = D1 / (k – g)

    where D1 represents the expected annual dividend per share for the next year k is the investor’s discount rate of return. You can estimate this using the Capital Asset Pricing Model, for example.

    and g is the anticipated dividend growth rate. We take this as a constant.

    When you have all these parameters, it is so easy to calculate the intrinsic value of the stock. For example, the S&P 500 dividend yield is about 2 %, 4.5% is how much you can expect dividends to grow due to the historical performances. So you can expect a long-run return at 6.5%.

    To show you how this model is true whether or not a company pays a dividend or reinvests it let’s show you this real example.

    Suppose your preferred company plans to pay a $2 dividend per share next year (D1). Also, you expect an increase of 10% per year following (g). Also, suppose you are expecting a rate of return on the stock to be 20% (k). Let’s say, the stock is trading at $20 per share now. Using the Gordon Growth formula, you can determine that the intrinsic value of one share of the stock is:

    $2.00/(0.20-0.10) = $20

    When you have all these parameters, it is so easy to calculate the intrinsic value of the stock. 

    You will very often find the Gordon Growth Model formula calculated:

    P = D1/(r-g)

    The stock price (P) is equal to the anticipated value of the dividend (D1) divided by the difference in the investor’s rate of return (r) minus the constant growth rate of the dividend (g).

    In essence, the Dividend Growth Model utilizes the investor’s required RoR and the dividend growth rate to calculate the value of the stock. 

    But dividends will increase at different percentages. For example, dividends will grow quickly and then reach a steady rate. The dividend is still supposed to be $2 per share next year, but dividends will progress yearly by 14%, then 20%, then 24%, and then stable rise by 10%.

    By using components of this formula, but examining every year the recent dividend growth individually, we can determine the current value of the stock.

    Following the inputs for our example Gordon Growth Model formula shows:

    D1 = $2.00
    k = 10%
    g1 (dividend growth rate, first year ) = 14%
    g2 (dividend growth rate, second year) = 20%
    g3 (dividend growth rate, third year) = 24%
    gn (dividend growth rate every year after) = 10%

    Let’s calculate the fair dividends for those years (we already find the dividend growth rate):

    D1 = $2.00
    D2 = $2.00 * 1,14= $2,28
    D3 = $2,28 * 1,20 = $2,74
    D4 = $2,74 * 1,24 = $3,40 

    The next step is to calculate the current value of every single dividend during the extraordinary growth period:

    $2,00 / (1,20) = $1.67
    $2,28 / (1,20)^2 = $1.58
    $2,74 / (1,20)^3 = $1.59
    $3,40 / (1,20)^4 = $1.64

    Now we can calculate the dividend in the year of stable growth of 10%:

    D5 = $3.40 * 1.10 = $3.74 

    Further, we can use the Gordon Growth Model’s formula to calculate the value of dividends in the 5th year:

    $3.74/(0.2-0.1) = $37.40

    This allows us to calculate the present value of the dividend’s growth in this 5th year, or how much that future growth is worth to us today:

    $37.40/(1.10)^5 = $23.22

    The final step is to calculate the current intrinsic value of stocks by summing up the present value of dividends in the first four years and the value of dividends in the fifth year.

    1.67+1.58+1.59+1.64+23.22=$29.7

    The main benefit of this formula is that it may cool down your emotions when trading. Calculating this can bring you down to the ground in growth periods, and also can support you when the market is falling.

    So, can the Gordon Growth Model’s formula predict the future market returns? In short, yes. 

    But the weakness of the Gordon growth model is its hypothesis that there will be a constant growth in dividends which is rare. So, you can use this formula for companies with stable growth rates.

  • Market Dictionary And Jargon In Trading Options

    Market Dictionary And Jargon In Trading Options

    Market Dictionary And Jargon In Trading Options
    All the phrases that you’ll meet in the stock, Forex, and currency markets are explained. Especially for the options trading.

    By Guy Avtalyon

    Market dictionary and jargon can be confusing for people that just enter any market. Here you’ll find the meaning of most used terms. Each area has its own specific vocabulary and jargon.

    If you want to participate in the stock market, you should also know some basic terms and jargon.  In front of you is the short market dictionary and jargon. 

    Of course, in order to understand better what they are talking about. So, here you can find a Market dictionary with basic terms

    LONG – meaning in the market dictionary

    Describes a position (in stock and/or options) in which you have purchased and own that security in your brokerage account. Let me explain, if you have to buy the right to buy 100 shares of a stock, and are holding that right in your account, you are long a call contract.

    If you have to buy the right to sell 100 shares of a stock and are holding that right in your account, you are long a put contract. Say, you have purchased 1,000 shares of stock and are holding that stock in your brokerage account, or elsewhere, you are long 1,000 shares of stock.

    When you are long an option contract: you have the right to exercise that option at any time prior to its expiration and your potential loss is limited to the amount you paid for the options contract.

    SHORT   

    Describes a position in options in which you have written a contract (sold one that you did not own). In return, you now have the obligations in terms of that option contract.  If the owner exercises the option, you have an obligation to meet. And you have sold the right to buy 100 shares of stock to someone else, you are short a call contract.

    But, if you have sold the right to sell 100 shares of stock to someone else, you are short a put contract.

    What else our Market dictionary can say about this? When you write an option contract you are creating it. The writer collects and keeps the premium received from its initial sale.

    If you are short you are the writer of an option contract and you can be assigned an exercise notice at any time during the life of the option contract.  All option writers should be informed that assignment prior to expiration is a distinct possibility and your potential loss on a short call is theoretically unlimited.

    This means the risk of loss is limited by the fact that the stock cannot fall below zero in price. Although technically limited, this potential loss could still be very large if the underlying stock declines in price.

    OPEN –  meaning in the Market dictionary 

    The opening transaction is what adds to, or creates a new trading position. It can be a purchase or a sale.

    Opening purchase – a transaction in which the purchaser’s intention is to create or increase a long position in a given series of options.

    Opening sale – a transaction in which the seller’s intention is to create or increase a short position in a given series of options

    CLOSE 

    A closing transaction is reducing or eliminating an existing position by an offsetting purchase or sale. The closing purchase is a transaction in which the purchaser’s intention is to reduce or eliminate a short position in the series of options.

    This transaction is known as “covering” a short position. The Closing sale is a transaction in which the seller’s intention is to lessen or eliminate a long position in the series of options.

    What are LEVERAGE AND RISK in the Market dictionary

    Options can provide leverage. That means an option buyer can pay a small premium for market exposure in relation to the contract value (usually 100 shares of the underlying stock).

    The investor may have a large percentage of gains from comparatively small, favorable percentage moves in the underlying equity. Leverage also has downside consequences.

    If the underlying stock price does not rise or fall as anticipated, leverage can increase the investment’s percentage loss.

    Options offer their owners a predetermined, set risk.

    But, if the owner’s options expire with no value, this loss can be the entire amount of the premium paid for the option. An uncovered option writer may have unlimited risk.

    What is the strike price

    In trading, options determine whether that contract is in-the-money, at-the-money, or out-of-the-money.

    Say the strike price of a call option is less than the current market price of the underlying security.

    Then say, the call means to be in-the-money. Because the holder of this call has the right to buy the stock at a price which is less than the price he would have to pay to buy the stock in the stock market.

    If the strike price equals the current market price, the option is said to be at-the-money.

    What is Intrinsic value 

    It is the amount by which an option, call or put, is in-the-money at any given moment.
    By definition, an at-the-money or out-of-the-money option has no intrinsic value; the time value is the total option premium.
    This does not mean that you can get these options at no cost.

    The amount by which an option’s total premium exceeds intrinsic value is called the time value portion of the premium. It is the time value portion of an option’s premium that is affected by fluctuations in volatility, dividend amounts, interest rates, the motions in time.

    There are various factors that give options value and affecting the premium at which they are traded. Altogether, these factors determine time value. 

    These are certainly not the only so-called professional terms on the stock market. This Trading dictionary is just a collection of basic terms. Very soon you will have the opportunity to read the Great Trading

    Dictionary, that Traders Paradise is preparing for our readers. But they are some of the most common ones you will meet when you step into this world.