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.