The Gordon Growth Model

The Gordon Growth Model is a powerful stock valuation tool, frequently used by novice investors as well as professional ones. The Gordon Growth method uses a stock's current dividend payment and expected growth rate in dividends to arrive at a fair stock price. The model has some limitations, and it shouldn't be relied on as the only stock-picking tool. Nevertheless, it's a key pillar of financial theory.

Defining The Gordon Growth Model

The Gordon Growth Model was developed by professor Myron Gordon of the finance faculty of the University of Toronto. It can be summed up with the equation (P) = D divided by (k minus G). P stands for stock value, D stands for expected dividend per share one year from now, k stands for required rate of return for the buyer, and G stands for growth rate in dividends.

In other words, if an investor knows the dividend in a year and at what rate that dividend will grow, she can calculate the stock's value. The value is what the stock is worth, given its expected dividends, and it represents the most that an investor should pay.

Finding the Input

Two of the inputs in this dividend growth model are easy to find. The dividend to be paid in a year is usually available by searching the news, since it is publicly announced by the company. The investor also knows what his required return is. This is the return that makes investing in the stock market worthwhile considering the risks involved, and it varies for every investor. The tricky part is estimating at what rate the dividends will grow. The Gordon Growth method requires an ability to guess such things as which product will perform better in the marketplace. This makes the process very hard and inexact, at best.

Evaluating Limitations of the Model

The Gordon Growth method is applicable only if the stock's dividend will grow at a constant rate. If the growth rate is uneven, the model is not usable. In reality, dividend growth rates are rarely constant. After rapid growth, the company's profits -- and therefore its dividends -- might hit a roadblock.

On the other hand, a company with stagnant dividends could bring in a new management team that would turn the company around and boost dividends. In these cases, this beautifully simple dividend growth model isn't applicable. If the company's dividends grow unevenly, the analyst can use other mathematical techniques to arrive at an approximate fair price of the stock.

Application in Finance

Although the growth rate of dividends is rarely constant in real life, and although it's hard to predict, a dividend growth model is a very powerful tool in finance. By using the market price and the next dividend of the stock, the investor can solve for the dividend growth rate that would justify such a price.

For example, if the stock is selling for $40 and the next dividend is $1 and the investor's required rate of return is 10 percent, the equation reads: $40 = $1 / (0.1 minus G). Solving for G results in 0.075 or 7.5 percent. If the investor thinks that dividend payments can realistically grow at 7.5 percent annually for the foreseeable future, the stock price is justified. If this growth is unlikely, the stock is too expensive for that investor.