Gordon Growth Model (GGM)

The Gordon Growth Model is a method used to estimate the intrinsic value of a stock by forecasting all its future dividends and assuming these dividends grow at a stable, constant rate. It is particularly relevant for mature companies in industries such as utilities, consumer staples, or established financial institutions where dividends are stable and predictable.

The model was introduced by Professor Myron J. Gordon in the 1960s and remains a cornerstone in equity valuation. It is part of the broader Dividend Discount Models (DDM) but focuses specifically on a constant growth scenario.

The model works by linking three key variables: the expected dividend per share, the growth rate of dividends, and the investor’s required rate of return.

Here is how the process functions step by step:

1. Dividend Forecasting – Analysts estimate the dividend expected to be paid in the next year.
   

2. Growth Rate Estimation – The expected rate at which dividends will grow annually is identified, usually based on past performance, industry trends, or company policies.
   

3. Required Rate of Return – This is the return investors expect for investing in the company’s equity, factoring in market risk.
   

4. Valuation Calculation – The Gordon Growth Model formula is applied to arrive at the stock’s theoretical fair value.
   

By combining these inputs, the GGM establishes a direct link between expected dividends and stock value.

Let’s consider an expanded, step-by-step example:

• Current dividend (D₀): ₹4 per share
  

• Expected growth rate (g): 6% per year
  

• Required rate of return (r): 11%
  

Step 1: Calculate next year’s dividend (D₁)
D₁ = D₀ × (1 + g) = ₹4 × 1.06 = ₹4.24

Step 2: Apply the formula
P = D₁ ÷ (r – g)
P = ₹4.24 ÷ (0.11 – 0.06)
P = ₹4.24 ÷ 0.05 = ₹84.8

Step 3: Interpretation
According to the GGM, the fair value of the stock is ₹84.8. This comparison indicates how the model interprets valuation differences, not an investment recommendation.

This interpretation is not a recommendation but simply how the model is designed to guide valuations.

1. Dividends are expected to grow at a constant rate indefinitely.
   

2. The company operates in a stable business environment with consistent earnings and dividend policies.
   

3. The required rate of return is higher than the constant dividend growth rate.
   

4. The firm’s capital structure and risk profile remain relatively unchanged over time.
   

5. Dividends represent a consistent and sustainable portion of the company’s earnings.
   

6. The company is assumed to continue operations indefinitely, allowing perpetual dividend growth.
   

1. It offers a straightforward method to estimate a company’s intrinsic value based on expected future dividends.
   

2. The model clearly illustrates how dividend growth rate and required rate of return influence valuation.
   

3. It provides a quick and consistent benchmark for comparing dividend-paying companies.
   

4. The model is particularly useful for valuing mature firms with stable earnings and predictable dividend policies.
   

5. It simplifies valuation by using limited inputs, making it easy to apply for long-term assessments.
   

The model offers several advantages that make it widely used among analysts:

• Simplicity – Straightforward formula with clear inputs.
  

• Dividend Focus – Emphasises dividends, a tangible and measurable return for investors.
  

• Long-Term Orientation – Suited for valuing established companies with predictable dividend policies.
  

• Benchmarking Tool – Provides a baseline valuation that can be compared against market prices.
  

While useful, the model has limitations that reduce its applicability in certain contexts:

• Constant Growth Assumption – Real-world dividends rarely grow at a constant rate forever.
  

• Dividend Dependency – Cannot be applied to companies that do not pay dividends.
  

• High Sensitivity – Small changes in growth or discount rates cause large shifts in valuation.
  

• Limited Scope – Less effective for high-growth, cyclical, or startup companies.

The Gordon Growth Model provides a clear, dividend-focused framework for valuing stable, dividend-paying companies. While it offers simplicity and long-term insights, it also has limits due to its constant growth assumption and sensitivity to inputs. For a balanced approach, analysts often use GGM alongside other valuation models.

This valuation method should not be considered for taking any investment decisions. This content is for informational purposes only and the same should not be construed as investment advice. Bajaj Finserv Direct Limited shall not be liable or responsible for any investment decision that you may take based on this content.