Gordon Growth Model
The Gordon Growth Model (GGM), also known as the Dividend Discount Model (DDM) with constant growth, is a stock valuation methodology that estimates the intrinsic value of a share by discounting all future dividends, assumed to grow at a constant perpetual rate, back to the present at the required rate of return. It is a direct application of the present value of a growing perpetuity.
Key takeaways
- The model requires only three inputs: the next period's expected dividend (D₁), the required rate of return (r), and the constant dividend growth rate (g).
- A key constraint is that r must be strictly greater than g; otherwise the formula produces a negative or undefined valuation.
- The GGM is most appropriate for mature, dividend-paying companies with stable, predictable growth rates (e.g., utilities, consumer staples, financial institutions).
- The model's sensitivity to the growth rate assumption is extremely high: small changes in g can produce dramatically different valuations.
- Extensions of the model include the two-stage DDM and the H-model, which accommodate varying growth rates across different periods of a firm's lifecycle.
Explanation
The Gordon Growth Model was formally developed by Myron J. Gordon and Eli Shapiro in their 1956 paper 'Capital Equipment Analysis: The Required Rate of Profit,' building on earlier dividend discount frameworks. It provides a closed-form solution to the theoretically infinite series of discounted future dividends by exploiting the mathematical property of a geometric series converging when the discount rate exceeds the growth rate.
The intuition behind the model is straightforward: a share of stock is worth the present value of all cash flows it will ever generate. For a dividend-paying company, these cash flows are the periodic dividends. If dividends grow at a constant rate g forever and investors require a return of r on the investment, the stock price today equals D₁ / (r − g), where D₁ is the dividend expected to be paid one period hence. This formula captures the powerful compounding effect of growth — higher g means the numerator of successive discounted dividends shrinks more slowly, supporting a higher current valuation.
The model's practical application requires careful estimation of its three inputs. D₁ is typically estimated by multiplying the current annualized dividend by (1 + g). The required return r is often estimated using the Capital Asset Pricing Model (CAPM) or a build-up approach based on the risk-free rate plus an equity risk premium adjusted for company-specific risk. The growth rate g is the most consequential and contentious input; analysts typically anchor it to long-run sustainable growth rates (often estimated as the product of the retention ratio and return on equity) or to long-run nominal GDP growth as an upper bound for perpetuity growth.
Despite its elegance, the GGM has well-known limitations. It cannot value companies that pay no dividends or companies in high-growth phases where g exceeds r. It is extremely sensitive to small changes in the g assumption: for a company with r = 9% and g = 7%, reducing g to 6% reduces the estimated value by 33%. For these reasons, the GGM is most credibly applied as one element of a multi-methodology valuation rather than as a standalone tool. The CFA Institute's equity analysis curriculum treats the GGM as foundational — a building block for understanding the relationship between growth, profitability, and stock valuation even when more sophisticated multi-stage models are ultimately used.
Formula
P₀ = D₁ / (r − g), where D₁ = D₀ × (1 + g), r = required rate of return, g = constant dividend growth rate (g < r)
Example
Utility company ABC Electric currently pays an annual dividend of $2.40 per share. The dividend is expected to grow at a constant rate of 4% per year in perpetuity, reflecting the regulated nature of the business. Using CAPM, the required return on equity is estimated at 8.5%. Applying the GGM: D₁ = $2.40 × 1.04 = $2.496. Intrinsic Value = $2.496 / (0.085 − 0.04) = $2.496 / 0.045 = $55.47 per share. If the stock currently trades at $50.00, it appears undervalued by approximately 10%, suggesting a potential buy opportunity. If g were assumed to be 5% rather than 4%, the estimated value would be $2.52 / 0.035 = $72.00 — illustrating the extreme sensitivity to the growth assumption.
Related terms
Capital Asset Pricing Model Current Ratio Discount Rate Dividend Dividend Discount Model Earnings Quality Equity Equity Risk Premium Intrinsic Value Normalized Earnings Perpetuity Precedent Transaction Analysis