What is the Gordon Growth Model?

//What is the Gordon Growth Model?
What is the Gordon Growth Model? 2017-10-04T22:20:39+00:00

Definition: The Gordon Growth Model (GGM) is a valuation model that values a stock by discounting the dividends that are distributed to a firm’s shareholders.

What Does Gordon Growth Model Mean?

What is the definition of Gordon Growth Model? Also known as Gordon Dividend Model, the Gordon Growth Model assumes that a firm is expected to achieve a steady growth, will maintain a stable financial leverage, and will pay out its free cash flows to its shareholders in the form of dividends. This model assumes that the dividend per share grows at a constant rate in perpetuity and therefore, the present value of a firm is calculated based on this assumption.

To calculate the fair value of a stock using the GGM formula, we need to know:

  • D1 = the expected future value of dividends
  • K = cost of equity, which the required rate of return by investors
  • g = the stable dividend growth rate, in perpetuity

The formula to calculate the fair value of a stock is P = D1 / ( k – g ).

Let’s look at an example.

Example

A technology company has declared a quarterly dividend of $0.85 per share, reaching an annualized dividend of $3.40 for the coming fiscal year. Analyst consensus estimates that the firm will increase its annualized dividend at a constant rate of 4% annually thereafter. The cost of equity for this blue chip technology firm is 12%, and its stock currently trades at $65. Can we use the GGM to calculate the stock’s fair price?

The answer is yes.

P = D1 / ( k – g ) = ( $3.40 x ( 1 + 4% ) ) / ( 0.12 – 0.04 ) = $3.54 / 0.08 = $44.2

According to the GGM, the stock of the technology firm should trade at $44.2. Instead, it trades at $65. This indicates that the stock is overvalued, which means that investor confidence is high for this technology firm, and investors trust their money to it.

Summary Definition

Define Gordon Growth Model: GGM is method that investors use to value a stock based on its dividend distributions.