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)
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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).
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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.
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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
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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.