What is the Gordon Growth Model?

This concept is covered in J10 Discretionary investment management and J12 Securities advice and dealing so could appear in AF4, the advanced investment planning paper too. In this article, we look at its features.

Gordon’s Growth Model, also referred to as the dividend discount model is a way of measuring the value of a share based on the company’s future dividends.  The theory is that the share is worth the total of all its future dividend payments discounted back to their present value.

In order to value a share, an estimate is needed for the following year’s dividend and what the required rate of return is from the investor.

Example

If we assume that a company pays a dividend of 10p this year and the required return is 15% and that it is expected to continue at this level, then the price of the share should be the dividend divided by the return on equity – 10p/15 = 67p.

This, however, does not consider that most would hope that dividends will rise -which is where Gordon’s growth model comes in.  This 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.

The formula is:

Share price =

dividend/(return required – dividend growth)

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.

Strengths and Weaknesses of the Gordon Growth Model

This model has its strengths and weaknesses.  It is widely used and easy to understand, and because market conditions are not taken into account, it can be used to compare different companies.

However, it does assume a single constant growth rate for dividends, so it has limited use for companies that have rapidly changing dividend patterns from year to year.  However, where companies have predictable dividends, such as 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 or business valuation.

Grab the resources you need!

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Alternatively, you can download taster resources for AF4 or J10 you’re revising for either of those exams.