Gordon Growth Model (GGM) Definition

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. It is a popular and straightforward variant of a dividend discount model (DDM).

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

• The Gordon Growth Model is a popular and straightforward example of a dividend discount model that assumes dividends grow at a constant rate in perpetuity.
• Because the model assumes a constant growth rate, it is generally only used for companies with stable growth rates in dividends per share.
• The model attempts to calculate the fair value of a stock irrespective of the prevailing market conditions.

Where:

P is the current stock price;

g is the constant growth rate in perpetuity expected for the dividends; 

r is the constant cost of equity capital for that company (or rate of return); and

D₁ is the value of the next year's dividends.

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, the growth rate in dividends per share, and required rate of return. Dividends (D) per share represent the annual payments a company makes to its common equity shareholders, while the growth rate (g) in dividends per share is how much the rate of dividends per share increases from one year to another. The required rate of return (r) is a 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.

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 the simple formula above, which is based on mathematical properties of an infinite series of numbers growing at a constant rate.

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 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.

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 currently pays a $3 dividend per share (D₁), which is expected to increase by 5% annually (g). 

The intrinsic value (p) of the stock is calculated as: $3 / (0.08 - 0.05) = $100.

According to the Gordon Growth Model, the shares are currently $10 overvalued in the market.

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 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.