How to Determine Stock Prices in a Constant Growth Model

The constant growth model, or Gordon Growth Model, is a way of valuing stock. It assumes that a company's dividends are going to continue to rise at a constant growth rate indefinitely. You can use that assumption to figure out what a fair price is to pay for the stock today based on those future dividend payments.

Dividends and Stock Price

When investors put money into a stock, they often are hoping to hold onto the stock for a certain amount of time and then sell it to another investor for a higher price. Ultimately, though, there needs to be a way for investors to make money from a stock beyond simply speculative buying and selling to make those stock prices worthwhile.

That often comes in the form of dividends, which are payments from the company that issued the stock to the shareholders in proportion to how much stock they own. Some stocks are known for paying a steady dividend over time. These are usually blue chip stocks in stable industries, such as big and established industrial companies, utilities and similar businesses. Some also return money to investors by buying back stock, essentially swapping money for outstanding stock held by investors.

Some growth stocks don't pay dividends at all, instead investing profits into continued expansion of the business, which shareholders bet will ultimately lead to a bigger payoff later on. Some companies also may shrink or stop paying their dividends when they hit a tough moment in the economy.

Even some onetime blue chip companies can see bumps in the road that affect their ability to pay steady dividends.

The Constant Growth Model

For a company that pays out a steadily rising dividend, you can estimate the value of the stock with a formula that assumes that constantly growing payout is what's responsible for the stock's value. You can use a mathematical formula called the constant growth model, or Gordon Growth Model, to make this calculation or find a stock valuation calculator tool online or in a smart phone app to do the computation for you.

The formula is P = D/(r-g), where P is the current price, D is the next dividend the company is to pay, g is the expected growth rate in the dividend and r is what's called the required rate of return for the company. The required rate of return is the minimum return on their investment that investors will accept to own the stock.

For example, consider a company that pays a $5 dividend per share, requires a 10 percent rate of return from investors and is seeing its dividend grow at a 5 percent rate. A fair price, under this model, is P = 5/(0.10-0.05) = $100 per share. At a higher price, investors won't get the desired rate of return, so they'll sell the stock and lower the price. At a lower price it will be a bargain since they'll get a higher rate than required, meaning other investors will bid up the price.

Using the Growth Model Data

If you have an estimate of the required rate of return and the growth rate on the dividend, which you can usually calculate based on recent past dividends, you can estimate a fair price to pay for the stock. In theory, you'd want to buy the stock if the price is below that level and sell it if you own it and it's well above that price.

In practice, you will also want to consider other factors, such as the price of other comparable stocks, possible returns from other investments entirely and factors that might cause the stock's dividend to deviate from that steady growth schedule. For example, a business that's doing well presently but it is in a rapidly changing industry might raise concerns.