# Gordon Growth Model Explained: Stock Valuation Formula

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

The Gordon Growth Model (GGM), a crucial tool in financial valuation, helps in determining a stock's intrinsic value based on expected future dividends growing at a constant rate. As a straightforward variant of the [dividend discount model (DDM)](https://www.investopedia.com/terms/d/ddm.asp), it is particularly valuable for analyzing companies with stable dividend growth.

The model discounts the infinite series of future dividends to present value, offering investors insights into whether a stock is undervalued or overvalued relative to its current market price. By using dividends per share, growth rates, and the required rate of return as inputs, GGM streamlines the evaluation of a stock's fair value, especially for companies with predictable dividend patterns.

### Key Takeaways

*   The Gordon Growth Model (GGM) is a tool used to determine the intrinsic value of a stock based on a series of dividends that grow at a consistent rate.
*   GGM is best applied to companies with stable dividend growth, as it assumes dividends will increase at a constant rate indefinitely.
*   The formula involves three main inputs: expected dividends per share, the growth rate of these dividends, and the required rate of return.
*   Limitations include its reliance on stable dividend growth and potential issues in valuation when the required rate of return is lower than the growth rate.
*   If the calculated intrinsic value is higher than the current market price, the stock is considered undervalued, warranting a purchase; if lower, it's overvalued, suggesting a sale.

![Gordon Growth Model](https://www.investopedia.com/thmb/cpZ7jJ6d0Vl3twSrr2dJtAktJJc=/1500x0/filters:no_upscale():max_bytes(150000):strip_icc()/Gordon-Growth-Model-GGM-228042e32abb469f8145c64a4200d027.jpg)

*— Investopedia / Xiaojie Liu*

### Understanding the Gordon Growth Model Formula  

The Gordon growth model formula relies on the math of an infinite series of numbers that grow at a constant rate. The model's key inputs are [dividends per share (DPS)](https://www.investopedia.com/terms/d/dividend-per-share.asp), the growth rate of those dividends, and the required [rate of return (ROR)](https://www.investopedia.com/terms/r/rateofreturn.asp).

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

_Source: Stern School of Business, New York University._

### Why the Gordon Growth Model Matters  

The GGM attempts to calculate the [fair value](https://www.investopedia.com/terms/f/fairvalue.asp) 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.

### Key Assumptions Behind the Gordon Growth Model  

The Gordon growth model values a company's stock using an [assumption of constant growth](https://www.investopedia.com/ask/answers/032415/what-are-advantages-and-disadvantages-gordon-growth-model.asp) in dividend payments that a company makes to its common equity [shareholders](https://www.investopedia.com/terms/s/shareholder.asp). 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.

### Challenges and 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](https://www.investopedia.com/terms/b/businesscycle.asp) and unexpected financial difficulties or successes. This limits the model to firms with 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. If the required return rate equals the growth rate, the value per share goes to infinity.

> **Warning**
>
> The Gordon Growth Model is only useful for valuing companies that regularly pay dividends. It may be unreliable for growth stocks, as these companies often reinvest profits instead of distributing them as dividends.

## Practical Example of the Gordon Growth Model in Action

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 (D1), 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 Using the Gordon Growth Model

### Advantages

*   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.

### Disadvantages

*   The Gordon growth model ignores non-dividend factors (such as [brand loyalty](https://www.investopedia.com/terms/b/brand-loyalty.asp), customer retention, and [intangible assets](https://www.investopedia.com/terms/i/intangibleasset.asp)) that can add to a company's value.
*   It assumes that [a company's dividend growth](https://www.investopedia.com/articles/basics/04/072304.asp) rate is stable.
*   It can only be used to value stocks that issue dividends, which excludes, for example, most [growth stocks](https://www.investopedia.com/terms/g/growthstock.asp).

### Gordon Growth Model Pros & Cons

Pros

*   GGM is a simple and straightforward way to establish the intrinsic value of a stock.
    
*   Allows comparison between companies of different sizes and industries.
    
*   Does not require knowledge of current market conditions, which can make the calculation more complex.
    

Cons

*   Does not account for non-dividend factors that can also contribute to a company's value.
    
*   Assumes stable, continuous growth in dividends.
    
*   Can only be used for companies that issue dividends.
    

## What Does the Gordon Growth Model Tell You?

The Gordon growth model attempts to [calculate the fair value of a stock](https://www.investopedia.com/ask/answers/042415/when-can-i-use-dividend-discount-method-ddm-value-stock.asp) 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.

## Conclusion: Evaluating the Gordon Growth Model  

The Gordon growth model is a popular formula that's used to find the intrinsic value of a company's stock.  If the model's result is higher than a stock's market price, the stock is considered undervalued and a potential 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 always grow at a constant rate. This makes it useful only when considering the stock of those select companies with dividends that match that assumption.  If the required return rate is less than the dividend growth rate, the result is negative and worthless.

> **Article Sources**
>
> 1.  Stern School of Business, New York University. "[Dividend Discount Models](http://pages.stern.nyu.edu/~adamodar/pdfiles/valn2ed/ch13.pdf)," Pages 1-5.
>     
> 2.  Stern School of Business, New York University. "[Dividend Discount Models](http://pages.stern.nyu.edu/~adamodar/pdfiles/valn2ed/ch13.pdf)," Page 11.