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Gordon’s growth formula supports case for low volatility stocks

03-11-2014 | Insight formule-250x100px.jpgThe application of Gordon’s growth formula to a ‘Japan scenario’, low bond yields in combination with low expected growth and low inflation, supports the case for low volatility stocks. This simple formula (left side) states that the value of a stock is equal to the present value of the expected stream of dividends.

The way to apply Gordon’s growth formula is by rearranging it. This formula (right side) states that the dividend yield (D/P) should be equal to the difference between the discount rate and the growth rate in dividends and earnings. A higher dividend yield (D/P) is either a reflection of a higher discount rate (r) or lower growth (g). Low volatility stocks tend to have higher dividend yields (+2%/+3%) and lower discount rates (-3%/-4%) than high volatility stocks.

This means that the high volatility stock needs to achieve 5-7% higher dividend growth than the low volatility stock, in order to justify their valuation. However, it is very difficult for a firm to perpetually grow that much faster, especially taking into account a ‘Japan scenario’. In this scenario, the low volatility stocks are more attractive than the high volatility stocks.
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