What is the Gordon Growth Model?
The Gordon Growth Model – otherwise described as the dividend discount model – is a stock valuation method that calculates a stock’s intrinsic value. Therefore, this method disregards current market conditions. Investors can then compare companies against other industries using this simplified model.
Myron J. Gordon (Source: Globe and Mail)
What are the assumptions of the Gordon Growth Model?
The Gordon Growth Model assumes the following conditions:
- The company’s business model is stable; i.e. there are no significant changes in its operations
- The company grows at a constant, unchanging rate
- The company has stable financial leverage
- The company’s free cash flow is paid as dividends
What is the Gordon Growth Model formula?
Three variables are included in the Gordon Growth Model formula: (1) D1 or the expected annual dividend per share for the following year, (2) k or the required rate of return, and (3) g or the expected dividend growth rate. With these variables, the value of the stock can be computed as:
Intrinsic Value = D1 / (k – g)
To illustrate, take a look at the following example: Company A’s is listed at $40 per share. Furthermore, Company A requires a rate of return of 10%. Currently, Company A pays dividends of $2 per share for the following year which investors expect to grow 4% annually. Thus, the stock value can be computed:
Intrinsic Value = 2 / (0.1 – 0.04)
Intrinsic Value = $33.33
This result indicates that Company A’s stock is overvalued since the model suggests that the stock is only worth $33.33 per share.
Learn about alternative methods for calculating intrinsic value, such as discounted cash flow (DCF) modeling. In corporate finance, the DCF model is considered the most detailed and thus the most heavily relied on form of valuation for a business.
What is the importance of the Gordon Growth Model?
The Gordon Growth Model can be used to determine the relationship between growth rates, discount rates, and valuation. Despite the sensitivity of valuation to the shifts in the discount rate, the model still demonstrates a clear relation between valuation and return.
Applications of the model are demonstrated more in-depth in our corporate finance courses.
What are the limitations of the Gordon Growth Model?
The assumption that a company grows at a constant rate is a major problem with the Gordon Growth Model. In reality, it is highly unlikely that companies will have their dividends increase at a constant rate. Another issue is the high sensitivity of the model to the growth rate and discount factor used.
The model can result in a negative value if the required rate of return is smaller than the growth rate. Moreover, the value per share approaches infinity if the required rate of return and growth rate have the same value, which is conceptually unsound.
Furthermore, since the model excludes other market conditions such as non-dividend factors, stocks are likely to be undervalued despite a company’s brand and steady growth.
CFI is the official provider of the global Financial Modeling & Valuation Analyst (FMVA)™ certification program, designed to help anyone become a world-class financial analyst. Through these financial modeling courses, anyone in the world can become a great financial analyst.
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