The Gordon Growth Model, also known as the dividend discount model, measures the value of a publicly traded stock by summing the values of all of its expected future dividend payments, discounted back to their present values. It essentially values a stock based on the net present value (NPV) of its expected future dividends.
Gordon Growth Model: stock price = (dividend payment in the next period) / (cost of equity - dividend growth rate)
The advantages of the Gordon Growth Model is that it is the most commonly used model to calculate share price and is therefore the easiest to understand. It values a company's stock without taking into account market conditions, so it is easier to make comparisons across companies of different sizes and in different industries.
There are many disadvantages to the Gordon Growth Model. It does not take into account nondividend factors such as brand loyalty, customer retention and the ownership of intangible assets, all of which increase the value of a company. The Gordon Growth Model also relies heavily on the assumption that a company's dividend growth rate is stable and known.
If a stock does not pay a current dividend, such as growth stocks, an even more general version of the Gordon Growth Model must be used, with an even greater reliance on assumptions. The model also asserts that a company's stock price is hypersensitive to the dividend growth rate chosen and the growth rate cannot exceed the cost of equity, which may not always be true.
There are two types of Gordon Growth Models: the stable growth model and the multistage growth model.