I have a note I took which says ‘you can use the Gordon growth model even if the growth rate is declining by 5% indefinitely because it will never go to zero in that case. But if told the growth will go to zero, we’d have to use the residual income model.’
Is this true? Can’t we only use the Gordon growth model if growth is, at some point in the future, constant?
You need to look at this in terms of the relation of R to G.
G may be negative, and GGM still holds. GGM assumes that dividends grow indefinitely at a constant rate (Which can be less than o) - As a negative G can still be plugged in the formula. As with any DDM you need to ensure that R > G. If this is not the case the formula does not hold as the stock would have a negative value which is not possible.
I am not sure what you mean by the ‘the growth rate is declining by 5% indefinitely because it will never go to 0’ but essentially the lower the G becomes the greater the difference between R & G - therefore GGM still holds.
With regards to using RI over DDM, the two should give mutually consistent answers. They just approach things differently. RI does not require dividend paying companies and is not as affected by terminal value. It is widely considered that GGM is an unrealistic assumption as dividends do not constantly crow into perpetuity.
thnx!