Gordon Growth Model The Gordon Growth Model (GGM) is a dividend-discount valuation method that estimates a stock’s intrinsic value by assuming dividends grow at a constant rate forever. It’s a simple, widely used tool best suited for companies with stable, predictable dividend policies. The formula P = D1 / (r − g) Explore More Resources
Where:
P = intrinsic value (current stock price)
D1 = dividend expected next year
r = required rate of return (cost of equity)
g = constant perpetual growth rate of dividends If only the most recent dividend D0 is available, use D1 = D0 × (1 + g). Explore More Resources
Important condition: r must be greater than g. If r ≤ g, the model is invalid (value becomes infinite or negative). Why it matters GGM converts an infinite stream of growing dividends into a present value. If the model’s P is higher than the market price, the stock may be undervalued; if lower, it may be overvalued. The model isolates dividend-driven intrinsic value independent of short-term market noise. Explore More Resources
Key assumptions
* Dividends grow at a constant rate forever.
* The company exists indefinitely and continues paying dividends.
* The required rate of return (r) is constant.
* The model applies only to dividend-paying firms with stable growth.
Inputs and how to estimate them
* D1 (next year’s dividend): based on announced dividends or last paid dividend grown by expected g.
* g (growth rate): often estimated from historical dividend growth, earnings growth, or analyst forecasts. Must be realistic and sustainable.
* r (required return): can be estimated using models such as CAPM, or by using investor’s target return.
Example Assume:
D1 = $3
r = 8% (0.08)
* g = 5% (0.05) P = 3 / (0.08 − 0.05) = $100 Explore More Resources
If the stock trades at $110, the model suggests it is $10 overvalued. Strengths
* Simple and intuitive.
* Useful for quick valuations of mature, dividend-paying companies.
* Facilitates comparison across dividend-paying firms.
Limitations and cautions
* Relies on the strong assumption of constant, perpetual dividend growth — rarely true for most firms.
* Sensitive to small changes in r and g; estimation errors can produce large valuation swings.
* Not suitable for non-dividend or high-growth companies that reinvest earnings.
* Invalid if r ≤ g.
Practical tips
* Use GGM for mature firms with consistent dividend policies (utilities, consumer staples).
* Cross-check g against long-term GDP or industry growth to ensure plausibility.
* Perform sensitivity analysis across a range of r and g values.
* For firms with non-constant dividend stages, consider multi-stage dividend-discount models instead.
Conclusion The Gordon Growth Model is a compact, useful tool for valuing stable, dividend-paying companies. Its simplicity is an advantage, but its restrictive assumptions mean it should be applied selectively and supplemented with sensitivity testing or alternative valuation methods when appropriate. Explore More Resources