## What Is the Gordon Growth Model (GGM)?

The Gordon growth model (GGM) is a formula used to determine the intrinsic value of a stock based on a future series of dividends that grow at a constant rate. It is a popular and straightforward variant of the dividend discount model (DDM). The GGM assumes that dividends grow at a constant rate in perpetuity and solves for the present value of the infinite series of future dividends.

Because the model assumes a constant growth rate, it is generally only used for companies with stable growth rates in dividends per share.

### Key Takeaways

- The Gordon growth model (GGM) is a formula used to establish the intrinsic value of company stock.
- It assumes that a company exists forever and that there is a constant growth in dividends when valuing a company's stock.
- The GGM works by taking an infinite series of dividends per share and discounting them back to the present using the required rate of return.
- It is a variant of the dividend discount model (DDM).
- The GGM is ideal for companies with steady growth rates, given its assumption of constant dividend growth.

#### Gordon Growth Model

## Gordon Growth Model Formula

The Gordon growth model formula is based on the mathematical properties of an infinite series of numbers growing at a constant rate. The three key inputs in the model are dividends per share (DPS), the growth rate in dividends per share, and the required rate of return (ROR).

$\begin{aligned} &P = \frac{ D_1 }{ r - g } \\ &\textbf{where:} \\ &P = \text{Current stock price} \\ &g = \text{Constant growth rate expected for} \\ &\text{dividends, in perpetuity} \\ &r = \text{Constant cost of equity capital for the} \\ &\text{company (or rate of return)} \\ &D_1 = \text{Value of next year's dividends} \\ \end{aligned}$

*Source: Stern School of Business, New York University.*

## Importance of the Gordon Growth Model

The GGM attempts to calculate the fair value of a stock irrespective of the prevailing market conditions and takes into consideration the dividend payout factors and the market's expected returns. If the value obtained from the model is higher than the current trading price of shares, then the stock is considered to be undervalued and qualifies for a buy, and vice versa.

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 the rate of dividends per share increases from one year to another. The required rate of return is the minimum rate of return investors are willing to accept when buying a company's stock, and there are multiple models investors use to estimate this rate.

## Assumptions of the Gordon Growth Model

The Gordon growth model values a company's stock using an assumption of constant growth in dividend payments that a company makes to its common equity shareholders. The GGM assumes that a company exists forever and pays dividends per share that increase at a constant rate.

To estimate the intrinsic value of a stock, the model takes the infinite series of dividends per share and discounts them back to the present using the required rate of return.

## Limitations of the Gordon Growth Model

The main limitation of the Gordon growth model lies in its assumption of 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. The model is thus limited to firms showing stable growth rates.

The second issue occurs 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.

## Example of the Gordon Growth Model

As a hypothetical example, consider a company whose stock is trading at $110 per share. This company requires an 8% minimum rate of return (r) and will pay a $3 dividend per share next year (D_{1}), which is expected to increase by 5% annually (g).

The intrinsic value (P) of the stock is calculated as follows:

$\begin{aligned} &\text{P} = \frac{ \$3 }{ .08 - .05 } = \$100 \\ \end{aligned}$

According to the Gordon growth model, the shares are currently $10 overvalued in the market.

## Pros and Cons of the Gordon Growth Model

### Pros

- The GGM is commonly used to establish intrinsic value and is considered the easiest formula to understand.
- The model establishes the value of a company's stock without accounting for market conditions, which simplifies the calculation.
- This straightforward approach also provides a way to compare companies of different sizes and in different industries.

### Cons

- The Gordon growth model ignores non-dividend factors (such as brand loyalty, customer retention, and intangible assets) that can add to a company's value.
- It assumes that a company's dividend growth rate is stable.
- It can only be used to value stocks that issue dividends, which excludes, for example, most growth stocks.

## What Does the Gordon Growth Model Tell You?

The Gordon growth model attempts to calculate the fair value of a stock irrespective of the prevailing market conditions and takes into consideration the dividend payout factors and the market's expected returns. If the GGM value is higher than the stock's current market price, then the stock is considered to be undervalued and should be bought. Conversely, if the value is lower than the stock's current market price, then the stock is considered to be overvalued and should be sold.

## What Are the Inputs for the Gordon Growth Model?

The three inputs in the GGM are dividends per share (DPS), the growth rate in dividends per share, and the required rate of return (RoR). DPS is the annual payments a company makes to its common equity shareholders, while the DPS growth rate is the yearly rate of increase in dividends. The required rate of return is the minimum rate of return at which investors will buy a company's stock.

## What Are the Drawbacks of the Gordon Growth Model?

The GGM's main limitation lies in its assumption of 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. The model is thus limited to companies with stable growth rates in dividends per share. Another issue occurs 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.

## The Bottom Line

The Gordon growth model is a popular formula that's used to find the intrinsic value of a company's stock. Generally, when the model's calculation results in a figure that's higher than the current market price of a company's shares, the stock is seen as undervalued and should be considered a buy. When the GGM result is lower than the current trading price, the stock is seen as overvalued and should be considered a sell.

A downside of the Gordon growth model is its assumption that dividend payouts grow at a constant rate. This makes it useful only when considering the stock of those select companies with dividends that match that assumption. In addition, should the formula's required rate of return be less than the dividend growth rate, the result will be negative and of no value.