What Is the Gordon Growth Model?
The Gordon Growth Model (GGM), also called the Dividend Discount Model, estimates the intrinsic value of a stock based on its future dividends. It assumes dividends grow at a constant rate indefinitely. This model is ideal for valuing mature, stable companies like utilities or consumer staples with predictable dividend policies.
For example, if a company pays a $4 annual dividend expected to grow 5% yearly, the GGM calculates what that dividend stream is worth today. Investors use it to determine if a stock is overvalued or undervalued relative to its dividends. However, it’s less useful for high-growth tech firms or companies that don’t pay dividends.
How to Calculate the Gordon Growth Model
The formula is:
Stock Price = D1 / (r – g).
D1: Next year’s expected dividend.
r: Required rate of return (discount rate).
g: Constant dividend growth rate.
The model assumes dividends grow forever at rate "g," which must be less than "r" to avoid nonsensical results. If growth exceeds the discount rate, the formula breaks down.
Gordon Growth Model Calculation Example
Let’s say Company XYZ pays an annual dividend of $3.00 per share, expected to grow 4% yearly. Investors require a 10% return. First, calculate D1: $3.00 × (1 + 0.04) = $3.12. Then apply the formula: Stock Price = $3.12 / (0.10 – 0.04) = $3.12 / 0.06 = $52.00.
If the stock trades below $52, it might be undervalued. If it’s above $52, it could be overpriced—unless growth or return assumptions change. For instance, if the growth rate rises to 5%, the new price becomes
$3.15 / (0.10 – 0.05) = $63.00.
Why Use the Gordon Growth Model?
The GGM simplifies valuing stable dividend-paying stocks. It requires just three inputs, making it quick for screening investments. Analysts use it to compare stocks within sectors like telecoms or utilities, where dividends are reliable.
It also helps estimate market expectations. If a stock trades at $60 but the GGM values it at $50 (using reasonable "r" and "g"), it suggests the market expects higher growth or lower risk than your assumptions. This gap invites deeper research.
Interpreting the Gordon Growth Model
A higher growth rate "g" boosts the stock price, while a higher required return "r" lowers it. For example, a utility stock with a 3% growth rate and 8% required return will have a lower valuation than one with 4% growth and 7% return.
However, the model is sensitive to inputs. Small changes in "g" or "r" dramatically affect results. If Company ABC’s growth rate shifts from 4% to 4.5%, its value jumps 15–20%. Always test different scenarios to gauge valuation ranges.
Practical Applications of the Gordon Growth Model
Investors use the GGM to set target prices. For instance, if Coca-Cola’s dividend is expected to grow 3% annually and you require a 9% return, the model gives a baseline price to compare against its market value. Significant deviations signal buying or selling opportunities.
Financial advisors use it to explain dividend stock risks. A stock priced at $100 with a GGM value of $80 might be riskier than perceived, as the market assumes unrealistic growth. It also helps retirees assess if dividend yields can sustainably fund their income needs.
Limitations of the Gordon Growth Model
The model fails for companies with erratic dividends, high growth, or no dividends. Amazon, for example, reinvests profits instead of paying dividends, making the GGM irrelevant. It also assumes perpetual growth, which is unrealistic for cyclical industries like automotive or travel.
Even for stable firms, estimating "g" and "r" is subjective. Overestimating growth leads to inflated valuations. Always pair the GGM with other methods like discounted cash flow (DCF) or P/E ratios for balanced analysis.
Conclusion
The Gordon Growth Model is a timeless tool for valuing dividend-paying stocks, offering simplicity and clarity. By focusing on predictable dividends, it helps investors cut through market noise and assess long-term value. But it’s not foolproof. Treat its results as a starting point, not a final answer. Combine it with qualitative research and other valuation models.