What Is the Gordon Growth Model & How to Use It

The Gordon Growth Model is a financial tool used to estimate the intrinsic value of a company’s stock. This model posits that a stock’s worth is derived from the present value of all its future dividends, which are assumed to grow at a constant rate indefinitely. Its primary purpose is to provide investors with a method to assess whether a stock is currently trading below or above its true value, helping to guide investment decisions.

Core Components

To apply the Gordon Growth Model, three core variables are necessary. The first component is the expected dividend in the next period (D1). This figure represents the total dividend payment per share that a company is projected to distribute to its shareholders over the upcoming year.

The second variable is the required rate of return (r). This rate signifies the minimum annualized percentage return an investor expects to receive for holding a particular stock, considering the level of risk involved. For equity investors, this rate is often aligned with the company’s cost of equity.

Finally, the constant growth rate of dividends (g) is the third component. This represents the steady, perpetual rate at which a company’s dividends are expected to increase each year into the foreseeable future. The model assumes this growth rate remains consistent over an extended period.

Applying the Model

The Gordon Growth Model employs a straightforward formula to calculate a stock’s intrinsic value: V = D1 / (r – g). In this formula, ‘V’ represents the intrinsic value per share of the stock. This equation discounts the perpetually growing stream of future dividends back to their present value, providing an estimated fair price for the stock.

To illustrate, consider a hypothetical company, “Stable Corp.,” that is expected to pay a dividend of $2.00 per share in the upcoming year (D1). An investor determines their required rate of return (r) to be 10%. The company’s dividends are anticipated to grow at a constant rate (g) of 4% annually for the indefinite future.

Plugging these values into the Gordon Growth Model formula yields the following calculation: V = $2.00 / (0.10 – 0.04). This simplifies to V = $2.00 / 0.06. The intrinsic value of Stable Corp.’s stock is calculated to be approximately $33.33 per share.

Comparing this intrinsic value to the current market price of Stable Corp.’s stock can inform investment decisions. If the market price is lower than $33.33, the stock might be considered undervalued. Conversely, if the market price exceeds $33.33, the stock could be viewed as overvalued. The model thus provides a quantitative benchmark for evaluating a stock’s attractiveness.

Underlying Assumptions

The Gordon Growth Model relies on several theoretical assumptions. One primary assumption is that a company’s dividends will grow at a constant rate indefinitely into the future. This implies a perpetual and unchanging growth trajectory for dividend payments, simplifying the calculation of an infinite series of future cash flows. This constant growth rate is a central tenet that allows the model’s formula to converge to a finite value.

Another assumption is that the required rate of return (r) must always be strictly greater than the constant growth rate of dividends (g). If ‘r’ were equal to or less than ‘g’, the denominator (r – g) would become zero or negative, resulting in an undefined or negative intrinsic value. A negative valuation is conceptually unsound, as a stock cannot have a value less than zero. This condition ensures that the discounted sum of future dividends remains positive and finite.

The model also implicitly assumes that the company will continue to pay dividends forever, effectively having an infinite life. This concept of “perpetual dividends” means that the business will operate indefinitely, consistently generating earnings to support ongoing dividend distributions to shareholders.

Finally, the Gordon Growth Model presumes a stable business model for the company. This implies that the company’s operations are mature, predictable, and capable of sustaining the constant, perpetual growth in dividends. Without a stable business foundation, the assumption of constant and perpetual dividend growth becomes tenuous.

Practical Considerations

Applying the Gordon Growth Model in real-world scenarios requires careful consideration regarding the estimation of its inputs. The expected dividend in the next period (D1) is often estimated by analyzing a company’s historical dividend payments, recent dividend declarations, and forward-looking analyst forecasts. Similarly, the constant growth rate of dividends (g) can be projected using a company’s historical dividend growth trends, industry growth rates, or professional analyst predictions.

The required rate of return (r) is typically estimated using financial models such as the Capital Asset Pricing Model (CAPM) or by considering the weighted average cost of capital (WACC) for the company. CAPM, for instance, incorporates the risk-free rate, the market risk premium, and the company’s specific risk (beta) to arrive at a suitable required return for equity.

The applicability of the Gordon Growth Model is closely tied to whether a company’s characteristics align with the model’s underlying assumptions. The model is most appropriate for mature companies that have a long history of consistent dividend payments and a stable, predictable business model. Such companies are more likely to exhibit the constant, perpetual dividend growth that the model assumes. For instance, a well-established utility company might fit this profile more readily than a rapidly evolving technology startup.

Conversely, the model may be less suitable for companies that do not pay dividends, have erratic dividend payment histories, or operate in highly volatile industries. It is also less effective for companies experiencing periods of unusually high growth, as their dividend growth rates are unlikely to remain constant over an indefinite period. In these situations, other valuation methodologies might provide a more accurate assessment of a company’s intrinsic value.