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.

Most Popular

Prepare your portfolio for recession
Investment strategy

Prepare your portfolio for recession

A recession is looking increasingly likely. Add in a bear market and soaring inflation, and things are going to get very complicated for investors, sa…
27 Jun 2022
Market crash: have we hit bottom or is there worse to come?
Stockmarkets

Market crash: have we hit bottom or is there worse to come?

For a little while, markets looked like they were about to embark on a full-on crash. And that could still happen, says Dominic Frisby. Today, he look…
27 Jun 2022
What the end of the 1970s bear market can teach today’s investors
Stockmarkets

What the end of the 1970s bear market can teach today’s investors

The 1970s saw the worst bear market Britain has ever seen, with stocks tumbling 70%. Things have changed a lot since then, says Max King. But there ar…
28 Jun 2022