Gordon growth model: formula, example and limits
The Gordon growth model is one of the shortest valuation formulas in finance. With just three numbers, it gives an estimate of a share's value. This page explains the formula, works through an example and shows where it can mislead.
Quick answer
The Gordon growth model is a version of the dividend discount model that assumes a company's dividends will grow at a constant rate forever. Its formula is: Value = D1 / (r minus g), where D1 is next year's expected dividend, r is the required rate of return and g is the constant growth rate. It works only when r is greater than g.
Key takeaways
- It values a share from next year's dividend, required return and growth.
- Formula: Value = D1 / (r minus g).
- It assumes dividends grow at a constant rate forever.
- It works only when the required return exceeds growth.
- The same formula is used for terminal value in DCF.
What is the Gordon growth model?
It is named after economist Myron J. Gordon, who popularised it in the late 1950s. It takes the idea of the dividend discount model and simplifies it by assuming steady dividend growth with no end date.
Under this assumption, the sum of all future discounted dividends reduces to a short formula, which makes the method quick to use.
The formula explained
| Symbol | Meaning |
|---|---|
| D1 | Dividend expected next year |
| r | Required rate of return (cost of equity) |
| g | Constant annual dividend growth rate |
| Value | D1 / (r minus g) |
If you know only this year's dividend (D0), you can find D1 as D0 x (1 + g). The required return is usually the cost of equity, often estimated with CAPM.
A simple example
A company paid a dividend of Rs 10 this year. Dividends are expected to grow 5 percent a year, and the required return is 11 percent. Next year's dividend is 10 x 1.05 = Rs 10.50. The value is 10.50 / (0.11 minus 0.05) = 10.50 / 0.06 = Rs 175.
If the growth rate were 6 percent instead, the value would be 10.60 / 0.05 = Rs 212. A one-point change in growth raised the value by over 20 percent, which shows how sensitive the formula is. These numbers are only for illustration.
Where else is the formula used?
The same idea is used to estimate terminal value in a DCF, by replacing the dividend with free cash flow and using the discount rate as r. It can also be rearranged to estimate the cost of equity: r = D1 / Price + g.
What are the limits?
The model needs r to be greater than g. If growth is close to or above the required return, the formula gives a huge or negative value, which makes no sense. Growth forever should also be modest, in line with long-run economic growth.
It suits mature, stable dividend payers. It does not suit fast-growing firms, companies with irregular dividends or those that pay none. Dividends can also be cut, so they are not guaranteed.
The key point to remember
The Gordon growth model is a quick way to link dividends, growth and required return to value. Its simplicity is useful, but its results depend heavily on a few assumptions that should be chosen with care.
Frequently Asked Questions
What is the Gordon growth model?
It is a version of the dividend discount model that values a share assuming dividends grow at a constant rate forever.
What is the Gordon growth model formula?
Value = D1 / (r minus g), where D1 is next year's dividend, r is the required return and g is the growth rate.
Why must r be greater than g?
If growth equals or exceeds the required return, the formula gives an infinite or negative value, which is not meaningful.
Is the Gordon growth model used in DCF?
Yes. The same formula is used to estimate terminal value, using free cash flow instead of dividends.
Which companies suit the Gordon growth model?
It fits mature companies with stable, steadily growing dividends.
Disclaimer: Investments in the securities market are subject to market risks. Please read all related documents carefully before investing. This article is intended for informational and knowledge purposes only and should not be considered tax, financial, or investment advice. Tax laws and deductions may vary based on individual circumstances and regulatory changes. Readers are advised to consult a qualified tax advisor or financial professional before making any investment or tax planning decisions.
Indira Securities Private Limited (SEBI Reg. No.): NSE TM ID: 12866 | BSE TM ID: 663 | CDSL DPID: 17000 | SEBI Reg. No.: INZ000188930 | MCX TM ID: 56470 | NCDEX TM ID: 01277 | CDSL Reg. No.: IN-DP-90-2015 | CIN:U67120MP1996PTC085111 | RA SEBI Reg. No.: INH000023269 | IA SEBI Reg. No.: INA000021410 | SEBI Merchant Banking Reg. No.: INM000013536
