What it means
The model belongs to the dividend discount family, which holds that a share is worth the present value of all the cash it will ever pay its owner. Rather than forecasting every future dividend individually, the Gordon Growth Model assumes a single perpetual growth rate and collapses the whole stream into one fraction.
Its practical importance goes well beyond share picking. The same formula is used to calculate the terminal value at the end of a discounted cash flow model, and for most valuations that terminal value accounts for the majority of the total, so the assumptions inside this small equation carry enormous weight.
Applying it requires three inputs: next year's dividend or cash flow, the required rate of return, and the long-run growth rate. The required return usually comes from a capital asset pricing model calculation, while the growth rate should be anchored to something defensible such as long-term inflation plus the expected real growth of the economy.
The model behaves badly when the growth rate approaches the required return, because the denominator shrinks towards zero and the valuation heads towards infinity. Any growth rate at or above the discount rate produces a nonsensical answer, and even a rate one percentage point too high can inflate a valuation dramatically.
Its limitations define where it should be used. It suits mature, stable, dividend-paying businesses such as utilities and large consumer companies, and it suits terminal value calculations; it is a poor fit for young firms with irregular payouts or fast-changing growth.
In practice
Real-world examples.
Example
An equity analyst values a water utility that has raised its dividend by about 4% a year for two decades. With a required return of 7.5% and a growth assumption of 4%, the model produces a target price she then sanity-checks against the market price and the peer group.
Example
A corporate finance team building a five-year cash flow forecast uses the formula to set the terminal value, dividing year six free cash flow by the weighted average cost of capital less 2.5% long-run growth.
Example
A private investor screening dividend shares uses the model in reverse, taking the current share price and dividend to work out what perpetual growth rate the market must be assuming, then judging whether that assumption looks reasonable.
Think of it
“The Gordon Growth Model is like calculating what a perpetual series of growing payments is worth today.
Formula
Calculation
Value per share (P0) = D1 / (r - g), where D1 is next year's expected dividend, r is the required rate of return and g is the constant growth rate.
A utility company paid a dividend of $2.00 per share this year and management expects dividends to grow at 5% a year indefinitely. Next year's dividend is therefore D1 = $2.00 x 1.05 = $2.10.
Investors require a 9% return on shares of this risk. The value per share is $2.10 / (0.09 - 0.05) = $2.10 / 0.04 = $52.50.
The sensitivity is worth seeing. If the required return were 8% instead of 9%, the value would become $2.10 / (0.08 - 0.05) = $2.10 / 0.03 = $70.00, a 33% increase in valuation from a single percentage point of change, which is why sensible practice is to present a range rather than a single figure.Case study
Seen in the real world.
Pemberton Grid Holdings is a fictional regulated energy network used as an illustrative example. Its investor relations team valued the company internally using a dividend of $3.00 per share, a required return of 8% and a growth rate of 6%, producing $3.00 x 1.06 / 0.02 = $159.00 per share.
The board was delighted until an external adviser pointed out that 6% perpetual growth implied the network would eventually outgrow the entire economy it operated in. Rebuilding the model with a 3% growth rate gave $3.00 x 1.03 / 0.05 = $61.80 per share, a valuation less than half the original.
In this illustrative scenario the difference between the two numbers was not analysis but arithmetic sensitivity. Pemberton adopted a rule that any perpetual growth rate above long-run nominal economic growth had to be justified in writing to the audit committee.
Watch out
Common mistakes.
- Using a growth rate equal to or higher than the required return, which makes the denominator zero or negative and produces a valuation that is either infinite or meaningless.
- Putting this year's dividend into the formula instead of next year's expected dividend, which understates the value by exactly one year of growth.
- Applying the model to a fast-growing company with no dividend history, where the assumption of constant perpetual growth simply does not describe the business.
Questions
People also ask.
What growth rate should I use?
Something defensible over the very long run, typically in the region of expected inflation plus modest real growth, and never above the long-term growth rate of the wider economy.
Can the model be used for companies that pay no dividend?
Only by substituting free cash flow to equity for the dividend, which requires an assumption about what the company would be capable of paying out.
Why does terminal value matter so much?
Because in a typical discounted cash flow model it often represents well over half of the total value, so small changes to the growth or discount assumption move the answer more than the detailed forecast years do.
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