What is the 'Gordon Growth Model'
The Gordon growth model is used to determine the intrinsic value of a stock based on a future series of dividends that grow at a constant rate. Given a dividend per share that is payable in one year, and the assumption the dividend grows at a constant rate in perpetuity, the model solves for the present value of the infinite series of future dividends.
D = Expected dividend per share one year from now
k = Required rate of return for equity investor
G = Growth rate in dividends (in perpetuity)
Because the model simplistically assumes a constant growth rate, it is generally only used for companies with stable growth rates in dividends per share.
BREAKING DOWN 'Gordon Growth Model'
The Gordon growth model values a company's stock using an assumption of constant growth in payments a company makes to its common equity shareholders. The three key inputs in the model are dividends per share, growth rate in dividends per share and required rate of return. Dividends per share represent the annual payments a company makes to its common equity shareholders, while the growth rate in dividends per share is how much dividends per share increases from one year to another. The required rate of return is a minimum rate of return investors are willing to accept when buying a stock of a particular company, and there are multiple models investors use to estimate this rate.
The Gordon growth model assumes a company exists forever and pays dividends per share that increase at a constant rate. To estimate the value of a stock, the model takes the infinite series of dividends per share and discounts them back into the present using the required rate of return. The result is a simple formula, which is based on mathematical properties of an infinite series of numbers growing at a constant rate.
Limitations of the Gordon Growth Model
The main limitation of the Gordon growth model lies in its assumption of a constant growth in dividends per share. It is very rare for companies to show constant growth in their dividends due to business cycles and unexpected financial difficulties or successes. Therefore, the model is limited to firms showing stable growth rates. The second issue has to do with the relationship between the discount factor and the growth rate used in the model. If the required rate of return is less than the growth rate of dividends per share, the result is a negative value, rendering the model worthless. Also, if the required rate of return is the same as the growth rate, the value per share approaches infinity.