Gordon Growth Model
Value a stock using the Gordon Growth Model: P = D1/(r-g).
Calculate fair stock price from dividends, required return, and growth rate.
The Formula
The Gordon Growth Model, also known as the Dividend Discount Model, provides a simple way to estimate the intrinsic value of a stock based on its future dividends. The model assumes that dividends grow at a constant rate indefinitely and that the required rate of return is greater than the dividend growth rate.
Myron Gordon and Eli Shapiro published this model in 1956 in the United States. It builds on the idea that a stock is worth the present value of all its future dividend payments. When dividends grow at a constant rate forever, the infinite series of discounted dividends simplifies into this elegant formula.
The model works best for mature, stable companies that have a long history of paying and increasing dividends at a predictable rate. Utility companies, large consumer staples firms, and well-established blue-chip stocks are good candidates. The model is less suitable for high-growth companies that reinvest all earnings, pay no dividends, or have erratic dividend patterns.
A critical requirement is that the growth rate must be less than the required return. If g approaches r, the calculated price goes to infinity, which is not realistic. In practice, the long-term growth rate of dividends cannot exceed the long-term growth rate of the economy, which is typically around 2% to 5% per year. The required return is often estimated using the CAPM formula.
Despite its simplicity, this model provides a useful benchmark for checking whether a dividend-paying stock is overvalued or undervalued relative to its dividend fundamentals.
Variables
| Symbol | Meaning |
|---|---|
| P | Fair value (intrinsic price) of the stock |
| D1 | Expected dividend per share one year from now |
| r | Required rate of return (discount rate) |
| g | Constant annual dividend growth rate |
Example 1
Problem
A company just paid a dividend of $3.00 per share. Dividends are expected to grow at 4% per year. Your required return is 10%. What is the stock worth?
D1 = $3.00 × (1 + 0.04) = $3.12
P = $3.12 / (0.10 − 0.04) = $3.12 / 0.06
P = $52.00. The stock's intrinsic value is $52.00 per share.
Example 2
Problem
A utility stock pays a $1.50 dividend next year. The growth rate is 2.5% and the required return is 8%. The stock currently trades at $30. Is it overvalued?
P = $1.50 / (0.08 − 0.025) = $1.50 / 0.055
P = $27.27
The intrinsic value is $27.27, which is below the $30 market price. The stock appears overvalued by about $2.73 per share.
When to Use It
The Gordon Growth Model is best applied to dividend-paying stocks with stable, predictable growth.
- Valuing mature, dividend-paying stocks like utilities, banks, and consumer staples
- Quick sanity check on whether a stock's price is reasonable relative to its dividends
- Estimating the implied growth rate the market is pricing into a stock (rearrange to solve for g)
- Comparing intrinsic values across similar companies in the same industry