Gordon Growth Model

Sometimes known as the dividend discount model

What is the Gordon Growth Model?

The Gordon Growth Model – also known as the Gordon Dividend Model or dividend discount model – is a stock valuation method that calculates a stock’s intrinsic value, regardless of current market conditions. Investors can then compare companies against other industries using this simplified model. Major contributors to this model are Myron J. Gordon, Robert F. Weise, and John Burr Williams.

Gordon Growth Model

Myron J. Gordon (Source: Globe and Mail)

 

What are the assumptions under 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 rate
  • The company has stable financial leverage
  • The company’s free cash flow is paid as dividends

gordon growth example

 

How is the Gordon Growth Model computed?

Three variables are included in the Gordon Growth Model equation: (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 stock can be computed as:

Intrinsic Value = D1 / (k – g)

To illustrate, take a look at the following example: Company A’s stock is trading at $40 per share. Furthermore, Company A requires a rate of return of 10%. Currently, Company A pays $2 dividend per share for the following year and this is expected to increase by 4% annually. Thus, the value of stock is computed as:

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.

 

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 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 grow at a constant rate. Another issue is the high sensitivity of the model to the discount factor and growth rate.

The model can result in a negative value if the required rate of return is less 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.

 

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