Gordon’s growth model

Gordon’s growth model is a very simple but powerful way of valuing shares based on a company’s future dividends. It is sometimes called a “dividend discount” model.

Gordon's growth model is a very simple but powerful way of valuing shares based on a company's future dividends. It is sometimes called a "dividend discount" model.

In order to value a share, you need an estimate for next year's expected dividend per share, the long-run expected growth rate of dividends, and also the investor's required return. Once you have these, the model says that the price of a particular share should be next year's expected dividend per share, divided by the investor's required return, less the long-term dividend growth rate.

Let's say a company will pay a dividend of 10p per share, the long-term growth rate is 4%, and investors want an 8% return. The value of the share (to the investor) is 10p/(8%-4%) = 250p. This model is best suited to mature companies, such as utilities or tobacco companies that have steady and predictable dividends.

For example, it will not work for companies that don't pay any dividends at all, and it is also unsuitable for companies that are expected to have high rates of dividend growth for the next few years. This is because the growth rate will tend to be higher than the investor's required return, which means that the simple model will not work.

Recommended

Modern monetary theory (MMT)
Glossary

Modern monetary theory (MMT)

Modern Monetary theory, or MMT, has become popular on the left, both in the UK and abroad. (Wags say that it stands for "magic money tree".) 
21 Sep 2020
Price to sales ratio
Glossary

Price to sales ratio

A company's market cap divided by the company's annual sales (or revenue) gives us the price/sales ratio.
28 Aug 2020
Too embarrassed to ask: what is a p/e ratio?
Too embarrassed to ask

Too embarrassed to ask: what is a p/e ratio?

Find out how to use the price/earnings ratio (p/e ratio for short) – a useful starting place for investors looking to value a company.
26 Aug 2020
Stock split
Glossary

Stock split

A stock split increases the number of a corporation's issued shares by dividing each existing share.
21 Aug 2020

Most Popular

The Bank of England should create a "Bitpound" digital currency and take the world by storm
Bitcoin

The Bank of England should create a "Bitpound" digital currency and take the world by storm

The Bank of England could win the race to create a respectable digital currency if it moves quickly, says Matthew Lynn.
18 Oct 2020
What would negative interest rates mean for your money?
UK Economy

What would negative interest rates mean for your money?

There has been much talk of the Bank of England introducing negative interest rates. John Stepek explains why they might do that, and what it would me…
15 Oct 2020
Negative interest rates and the end of free bank accounts
Bank accounts

Negative interest rates and the end of free bank accounts

Negative interest rates are likely to mean the introduction of fees for current accounts and other banking products. But that might make the UK bankin…
19 Oct 2020