What is the Gordon Growth Model?

The Gordon Growth Model – otherwise described as the dividend discount model – is a stockStockWhat is a stock? An individual who owns stock in a company is called a shareholder and is eligible to claim part of the company’s residual assets and earnings (should the company ever be dissolved). The terms "stock", "shares", and "equity" are used interchangeably. valuation methodValuation MethodsWhen valuing a company as a going concern there are three main valuation methods used: DCF analysis, comparable companies, and precedent transactions that calculates a stock’s intrinsic value. Therefore, this method disregards current market conditions. Investors can then compare companies against other industries using this simplified model.

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Myron J. Gordon (Source: Globe and Mail)

What are the assumptions of the Gordon Growth Model?

The Gordon Growth Model assumes the following conditions:

The company’s business model is stable; i.e. there are no significant changes in its operationsThe company grows at a constant, unchanging rateThe company has stable financial leverageThe company’s free cash flow is paid as dividends

What is the Gordon Growth Model formula?

Three variables are included in the Gordon Growth Model formula: (1) D1 or the expected annual dividend per share for the following year, (2) k or the required rate of returnWACCWACC is a firm’s Weighted Average Cost of Capital and represents its blended cost of capital including equity and debt., and (3) g or the expected dividend growth rate. With these variables, the value of the stock can be computed as:

Intrinsic Value = D1 / (k – g)

To illustrate, take a look at the following example: Company A’s is listed at \$40 per share. Furthermore, Company A requires a rate of return of 10%. Currently, Company A pays dividends of \$2 per share for the following year which investors expect to grow 4% annually. Thus, the stock value can be computed:

Intrinsic Value = 2 / (0.1 – 0.04)

Intrinsic Value = \$33.33

This result indicates that Company A’s stock is overvaluedValuation InfographicOver the years, we"ve spent a lot of time thinking about and working on business valuation across a broad range of transactions. This valuation infographic since the model suggests that the stock is only worth \$33.33 per share.

Learn about alternative methods for calculating intrinsic valueIntrinsic ValueThe intrinsic value of a business (or any investment security) is the present value of all expected future cash flows, discounted at the appropriate discount rate. Unlike relative forms of valuation that look at comparable companies, intrinsic valuation looks only at the inherent value of a business on its own., such as discounted cash flow (DCF) modeling. In corporate finance, the DCF modelDCF Model Training Free GuideA DCF model is a specific type of financial model used to value a business. The model is simply a forecast of a company’s unlevered free cash flow is considered the most detailed and thus the most heavily relied on form of valuation for a business.

What is the importance of the Gordon Growth Model?

The Gordon Growth Model can be used to determine the relationship between growth rates, discount rates, and valuation. Despite the sensitivity of valuation to the shifts in the discount rate, the model still demonstrates a clear relation between valuation and return.

Applications of the model are demonstrated more in-depth in our corporate finance courses.

What are the limitations of the Gordon Growth Model?

The assumption that a company grows at a constant rate is a major problem with the Gordon Growth Model. In reality, it is highly unlikely that companies will have their dividends increase at a constant rate. Another issue is the high sensitivity of the model to the growth rate and discount factor used.

The model can result in a negative value if the required rate of returnCost of Preferred StockThe cost of preferred stock to a company is effectively the price it pays in return for the income it gets from issuing and selling the stock. They calculate the cost of preferred stock by dividing the annual preferred dividend by the market price per share. is smaller than the growth rate. Moreover, the value per share approaches infinity if the required rate of return and growth rate have the same value, which is conceptually unsound.

Furthermore, since the model excludes other market conditions such as non-dividend factors, stocks are likely to be undervalued despite a company’s brandIntangible AssetsAccording to the IFRS, intangible assets are identifiable, non-monetary assets without physical substance. Like all assets, intangible assets and steady growth.

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