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What is the Gordon Growth Model?

what is the gordon growth model

Definition of the Gordon Growth Model

  • The Gordon growth model, or GGM, is used to calculate the intrinsic value of a stock from future dividends.
  • The model only works for companies that pay out dividends, which have a constant growth rate.

What Impacts the Gordon Growth Model?

  • The required rate of return 
  • Dividend 
  • Dividend growth rate 

How to Calculate the Gordon Growth Model?

  • The intrinsic value of an equity is calculated by dividing the value of the next year’s dividend by rate of return less the growth rate.

P = D1/r – g

(Where P = current stock price, D1 = value of next year’s dividend, g = constant growth rate expected, and r = required rate of return.)

Why is the Gordon Growth Model Important? 

  • Compared to other valuation methods, the Gordon growth model is much more straightforward to calculate.
  • The Gordon growth model helps investors see whether the stocks are undervalued or overvalued.
  • With this model, the investors would make a more rational choice when trading stocks.

The Gordon Growth Model in Practice

  • For example, if a company lists its stock price at $50, has a required rate of return at 15% (r), pays a dividend of $1 per share you own, and has a constant growth rate of 6% then how would you calculate the stock value?
  • $1 ÷ (0.15 – 0.06) = $11.11 
  • The model would not be practical if the growth rate is equal or more than the required rate of return.
  • It is almost impossible for firms to have a constant growth rate over a long period, which violates the assumptions of GGM.