Gordon's growth model is a simple but powerful way of valuing shares based on the dividends that the company is expected to pay in future. It gets its name from Myron Gordon, an economist who originally published the method in the 1950s, and is the most common and straightforward example of a class of valuation methods called dividend discount models.
The theory behind these is that the value of a company is equal to the value of all the dividends that it will ever pay to investors, discounted back to their present value (so a dividend paid in five years’ time is worth less than a dividend paid tomorrow).
To apply the Gordon growth model, you need an estimate for next year’s dividend per share (D), the long-run expected stable growth rate of dividends (g), and the investor’s required return (r). The model says that the price (P) 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. Expressed as a formula, this is P = D ÷ ( r − g ).
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Let’s assume that a company will pay a dividend of 10p per share, the long-term growth rate is 4%, and the investor wants an 8% return. The value of the share to this investor is 10 ÷ ( 0.08 − 0.04 ) = 250p. In practice, we can almost never know what dividends a company will pay far into the future, but we can try out different scenarios to get a range of estimates for its fair value.
We can also invert the model and work out what assumptions are needed to justify the current share price of a company and whether they seem reasonable. The Gordon growth model will not work for stocks that do not currently pay any dividends or those where dividend growth is so high that g exceeds r. These problems can be solved by using a multi-stage model, where dividends start in the future, grow at higher rates for a finite period of time and then settle down to a steady, lower long-term rate.
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