Published On:Wednesday, 11 January 2012

Posted by Muhammad Atif Saeed

A model for determining the intrinsic value of a stock, based on a future series of dividends that grow at a constant rate. Given a dividend per share that is payable in one year, and the assumption that the dividend grows at a constant rate in perpetuity, the model solves for the present value of the infinite series of future dividends.

Where:
D = Expected dividend per share one year from now
k = Required rate of return for equity investor
G = Growth rate in dividends (in perpetuity)

The Gordon growth model is a type of dividend discount model used to value companies expected to grow at a constant rate forever. Most valuation models forecast growth for a certain time period before reverting to a Gordon growth model to estimate the ending value.

Because the model simplistically assumes a constant growth rate, it is generally only used for mature companies (or broad market indices) with low to moderate growth rates.

Strengths:

• Especially useful for valuing stable-growth dividend paying companies
• Useful for valuing broad-based equity indices
• Simplicity and clarity
• Helpful in understanding relationships between value, growth, required return and payout ratio
• Useful for estimating expected rate of return

Weaknesses:

• Output highly sensitive to assumptions for growth rate and required return
• Not practical for valuing non-dividend paying companies
• Not practical for valuing dividend paying stocks with unstable growth characteristics