Wall Street Prep

Gordon Growth Model

Understand the Concept of the Gordon Growth Model (GGM)

Learn Online Now

Gordon Growth Model

In This Article
  • What are some of the main assumptions used in the Gordon Growth Model (GGM)?
  • Which factors drive the calculated share price under the GGM approach?
  • For what type of companies is the GGM best-suited?
  • What are some of the pros/cons of using the GGM?

Gordon Growth Model Overview

The Gordon Growth Model (GGM), named after economist Myron J. Gordon, calculates the fair value of a stock by examining the relationship between three variables.

  1. Dividends Per Share (DPS): DPS is the value of each declared dividend issued to shareholders for each common share outstanding and represents how much money shareholders should expect to receive on a per-share basis.
  2. Dividend Growth Rate (g): The dividend growth rate is the projected rate of annual growth, which in the case of a single-stage GGM, a constant growth rate is assumed.
  3. Required Rate of Return (r): The required rate of return is the “hurdle rate” needed by equity shareholders to invest in the company’s shares with consideration towards other opportunities with similar risks in the stock market.

Given the fixed dividend issuance growth rate assumption, the Gordon Growth Model is suited for companies with steady dividend growth and no plans for adjustments.

Thus, the GGM is used most frequently for mature companies in established markets with minimal risks that would create the need to cut (or end) their dividend payout program.

Interpreting the Gordon Growth Model (GGM)

The Gordon Growth Model approximates the intrinsic value of a company’s shares using the dividend per share (DPS), the growth rate of dividends, and the required rate of return.

  • If the share price calculated from the GGM is greater than the current market share price, the stock is undervalued and could be a potentially profitable investment.
  • If the calculated share price is less than the current market price, the shares are considered overvalued.

Gordan Growth Model (GGM) Formula

The Gordon Growth Model (GGM) values a company’s share price assuming constant growth in dividend payments.

The formula requires three variables, as mentioned earlier, which are the dividends per share (DPS), the dividend growth rate (g), and the required rate of return (r).

Gordon Growth Model (GGM) = Next Period Dividends Per Share (DPS) / (Required Rate of Return – Dividend Growth Rate)

Since the GGM pertains to equity holders, the appropriate required rate of return (i.e. the discount rate) is the cost of equity.

If the expected DPS is not explicitly stated, the numerator can be calculated by multiplying the DPS in the current period by (1 + Dividend Growth Rate %).

For example, if a company’s shares are trading at $100 per share and minimum required rate of return of 10% (r) with plans to issue a $4.00 dividend per share (DPS) next year, which is expected to increase by 5% annually (g).

  • Value Per Share = $4.00 DPS / (10% Required Rate of Return – 5% Annual Growth Rate)
  • Value Per Share = $80.00

In our example, the share price of the company is overpriced by 25% ($100 vs $85).

DCF Terminal Value Calculation – Growth in Perpetuity Approach

Often referred to as the “Growth in Perpetuity Approach” in DCF analyses, another use-case of the Gordon Growth Model is to calculate the terminal value of a company at the end of the stage-one cash flow projection period.

To calculate the terminal value, a perpetual growth rate assumption is attached for the forecasted cash flows beyond the initial forecast period.

Gordon Growth Model Pros / Cons

The Gordon Growth Model (GGM) offers a convenient, easy-to-understand method for calculating the approximate value of a company’s share price.

As we saw earlier, the single-stage model requires only a handful of assumptions, but this aspect tends to restrict the accuracy of the model when it comes to high-growth companies with changing capital structures, dividend payout policies, etc.

Instead, the GGM is most applicable for mature companies with a consistent track record of profitability and issuance of dividends.

The main drawback to the GGM is the assumption that dividends will continue to grow at the same rate indefinitely.

In reality, companies and their business model undergo significant adjustments as time passes and as new risks emerge in the market.

Because of the assumption that dividends grow at a fixed rate perpetually, the model is most meaningful for mature, established companies with consistent growth in dividends.

Another concern for reliance on the GGM is that underperforming companies can issue large dividends to themselves (e.g. a reluctance to cut dividends) despite the deterioration in their financials.

Hence, a disconnect between the fundamentals of the company and the dividend policy can occur, which the GGM would not capture.

Excel Template Download

Now that we’ve discussed the assumptions of the Gordon Growth Model (GGM), we can move to an example exercise where we’ll be modeling a short-form GGM.

For access to the Excel file, fill out the form below:

dl
Submitting ...

Gordon Growth Model Example Calculation

In our example scenario, the following assumptions will be used:

Model Assumptions
  • Dividends Per Share (DPS) – Current Period: $5.00
  • Required Rate of Return (Ke): 8.0%
  • Expected Dividend Growth Rate (g): 3.0%

Based on those assumptions, the company has issued a dividend per share (DPS) of $5.00 in the latest period (Year 0), which is expected to grow at a constant 3.0% each year into perpetuity.

In addition, the required rate of return (i.e. the cost of equity) for this company is 8.0%.

Note that similar to a discounted cash flow model, if the expected perpetuity growth rate were to be greater than the required rate of return, adjustments to the assumptions would be required.

Otherwise, the calculated share prices from the model would be meaningless, and other valuation methods would be more appropriate.

Value Per Share Calculation in Year 0
  • Dividends Per Share (DPS): $5.00
  • Required Rate of Return (Ke): 8.0%
  • Expected Dividend Growth Rate (g): 3.0%
  • Value Per Share ($) = $5.00 DPS ÷ (8.0% – 3.0%) = $100

Gordon Growth Model Projection Period

Next, we’ll need to extend the assumptions across the forecast period from Year 1 to Year 5.

By multiplying the dividends per share (DPS) of $5.00 in Year 0 by (1 + 3.0%), we get $5.15 as the DPS in Year 1 – and this same process will be repeated for each forecast period.

As for the required rate of return and expected dividend growth rate, we can simply link to our model assumptions section and hardcode the amounts since both are assumed to remain constant.

Gordon Growth Model Share Price Calculation

In the final section, we’ll calculate the Gordon Growth Model derived value per share in each period.

The formula consists of taking the DPS in the period by (Required Rate of Return – Expected Dividend Growth Rate).

For example, the value per share in Year is calculated using the following equation:

  • Value Per Share ($) = $5.15 DPS ÷ (8.0% Ke – 3.0% g) = $103.00

Value Per Share

From the completed model output, we can see how from Year 0 to Year 5, the estimated share price grows from $100.00 to $115.93, which is driven by the incremental increase in the dividends per share (DPS) of $0.80 in the same time span.

GGM Done

Step-by-Step Online Course

Everything You Need To Master Financial Modeling

Enroll in The Premium Package: Learn Financial Statement Modeling, DCF, M&A, LBO and Comps. The same training program used at top investment banks.

Enroll Today
Comments
guest
0 Comments
Inline Feedbacks
View all comments
Share
Learn Financial Modeling Online

Everything you need to master financial and valuation modeling: 3-Statement Modeling, DCF, Comps, M&A and LBO.

Learn More
X

The Wall Street Prep Quicklesson Series

7 Free Financial Modeling Lessons

Get instant access to video lessons taught by experienced investment bankers. Learn financial statement modeling, DCF, M&A, LBO, Comps and Excel shortcuts.