Gordon Growth Model
The Gordon Growth Model is a Dividend Discount Model that values a company based on the theory that a stock is worth the discounted sum of all of its future dividend payments.
Gordon Growth Model
The Gordon Growth Model is a commonly used dividend discount model that values a company based on the theory that a stock is worth the discounted sum of all of its future dividend payments. The Gordon Growth Model is named after Myron J. Gordon, who originally published it in 1959.
Gordon Growth Model Formula
The Gordon Growth Model begins with the assumption that the value of a stock is equal to the sum of its future stream of discounted dividends.
Given a dividend per share that is payable in one year, and the assumption that the dividend grows at a constant rate in perpetuity, the formula for the Gordon Growth Model solves for the present value of the infinite series of future dividends.
Example Gordon Growth Model Calculation
Suppose that Stock X pays a $1 annual dividend and is expected to grow its dividend 7% per year. The investor's required rate of return is 8%. Plugging those numbers into the GGM formula gives you:
Value of Stock X = ($1 * (1 + 0.07))/ (0.08 - 0.07) = $107
Gordon Growth Model Interpretation
The Gordon Growth Model is useful primarily for blue chip companies and other mature companies where dividend growth is unlikely to change. If any of the assumptions built into the model are invalidated then the model becomes essentially worthless.
The model's greatest strength is its simplicity, but this can also be a disadvantage. Only a handful of factors are considered in the valuation and numerous assumptions must be made. For example, the formula assumes a single constant growth rate for dividends.
In the real world, however, dividend growth often changes from year to year for a variety of reasons. Companies may choose to conserve cash during industry downturns or spend cash to make an acquisition. In either case, the dividend growth rate would likely be at least temporarily affected. The Gordon Growth Model is also very sensitive to a required rate of return that is too close to the dividend growth rate.
Despite its shortcomings, the Gordon Growth Model continues to be widely used and especially popular for valuing companies in industries like banking and real estate, where dividend payments can be large and growth is relatively stable.