What is the Gordon Growth Model?
For those of you studying CII J12, the Securities Advice and Dealing module, you will have come across the Gordon Growth Model. In this article, we explain what it is (which will also be useful if you’re studying for AF4).
Basically the Gordon Growth Model is a version of a dividend discount model – a way of valuing shares based on a company’s future dividends.
Valuing a Share
In order to value a share, an estimate is needed for the following year’s dividend and the investor’s required rate of return.
Let’s assume a company pays a dividend of 10p this year, the required return is 15%, and it is expected to continue at this level. The price of the share should be the dividend divided by the return – 10p/15 = 67p.
Where the Gordon Growth Model Comes In
However, this doesn’t take into account that dividends will rise, which is where the Gordon Growth Model comes in. The model assumes that dividends will rise at a constant rate, so the model says that the price of a share should be next year’s dividend, again divided by the required rate of return by the investor less the long term growth rate of the dividend.
So if a dividend is paid of 10p, the long-term growth rate is 4%, and the investors want a 15% return, then the value of the share is now 10p/(15 – 4) = 91p.Do you know what the Gordon Growth Model is? Click To Tweet
Strengths and Weaknesses
This model has its strengths and weaknesses. It does assume a single constant growth rate for dividends, so it has limited use for companies that have changing dividend patterns from year to year. However, where companies have predictable dividends, such as the utility companies, then it’s a useful valuation model.
And in case you’re wondering who Gordon was, well the model was named in the 60s after the American economist, Professor Myron J. Gordon, who first published the method of stock valuation.
Grab the resources you need!
If you’re studying for your CII J12 exam, and you’re striving for a solid pass, you’ll need to be well prepared. Grab our free taster to try out one of Brand Financial Training’s resources for yourself. Click the link to download the J12 calculation workbook taster now!
Alternatively, you can download taster resources for AF4 you’re revising for that exam.