Gordon Growth Model
Key Takeaways
- The Gordon Growth Model values a stock as D₁ / (r - g), where D₁ is next year's dividend
- It assumes dividends grow at a constant rate forever, making it a perpetuity growth model
- The model works best for stable, mature companies with predictable dividend growth
- It is also used to calculate terminal value in multi-stage DCF models
Definition
The Gordon Growth Model (GGM), also known as the Gordon Dividend Model, is a simplified version of the dividend discount model (DDM) that values a stock by assuming its dividends grow at a constant rate indefinitely. Named after economist Myron Gordon, it remains one of the most widely taught and used valuation formulas in finance.
The formula is: Value = D₁ / (r - g), where D₁ is the expected dividend next year, r is the required rate of return, and g is the constant dividend growth rate. This elegant equation captures the idea that a stock's value depends on three factors: how much cash it pays, how fast those payments grow, and what return investors demand.
The GGM is commonly applied to Dividend Aristocrats and other stable dividend growers like Procter & Gamble (PG) and Coca-Cola (KO). It is also used to calculate terminal value in DCF models.
How It Works
To apply the Gordon Growth Model, you need three inputs. First, D₁ (next year's expected dividend), which equals the current annual dividend multiplied by (1 + g). Second, r (required rate of return), typically estimated using CAPM. Third, g (constant dividend growth rate), derived from historical growth or the retention ratio times return on equity.
The formula works because it is the mathematical solution to an infinite series of growing dividends discounted to present value. The critical constraint is that g must be less than r. If g equals or exceeds r, the formula produces a negative or infinite value, which is economically meaningless.
In practice, the growth rate g should not exceed the long-term nominal GDP growth rate (about 4-5%) because no company can sustain dividend growth faster than the overall economy indefinitely. The GGM is most accurate when applied over long time horizons to companies with stable, predictable businesses.
Example
Johnson & Johnson (JNJ) pays a current annual dividend of $4.96 per share and has grown its dividend at approximately 5% per year over the past decade. Using a required return of 9%, the Gordon Growth Model gives: D₁ = $4.96 × 1.05 = $5.21. Value = $5.21 / (0.09 - 0.05) = $5.21 / 0.04 = $130.25. If JNJ trades at $160, the stock appears overvalued by the GGM, though the model may undervalue the company if its actual growth prospects exceed the assumed 5% rate.
Why It Matters
The Gordon Growth Model is fundamental to finance because it provides a clear, intuitive link between dividends, growth, and stock value. It demonstrates that stock prices are driven by the interplay of expected cash returns, growth, and the discount rate. When interest rates rise (increasing r), the model shows why stock prices fall.
Beyond individual stock valuation, the GGM is used to estimate the cost of equity (by rearranging the formula: r = D₁/P + g), calculate terminal values in DCF models, and assess the implied growth rate embedded in a stock's current price. These applications make it an indispensable tool in corporate finance and equity analysis.
Advantages
- Simple and elegant formula that clearly links dividends, growth, and value
- Useful for quickly estimating the value of stable dividend-paying stocks
- Can be rearranged to estimate cost of equity or implied growth rate
- Widely used for terminal value calculations in multi-stage DCF models
Limitations
- Assumes constant dividend growth forever, which rarely holds precisely
- Extremely sensitive to small changes in the growth rate and required return
- Cannot be used for non-dividend-paying stocks or companies with erratic dividends
- Breaks down when the growth rate approaches or exceeds the required return
Frequently Asked Questions
Related Terms
Browse more definitions in the financial terms glossary.