The Gordon Growth Model is named after economist Myron J. Gordon of the University of Toronto, who originally published the model along with Eli Shapiro in 1956.
Also known as the Dividend Discount Model, Gordon’s model is used for valuing stocks that pay regular dividends that are expected to grow at a constant rate.
The formula is P0 = D1 / (k – g)
- P0 is the current price (or value)
- D1 is the expected dividend in Year 1 (the forward dividend)
- k is the discount rate (or cost of equity capital)
- g is the expected growth rate
If we want to derive the expected annual return on investment for a dividend stock, the formula can be restated as
k = D1 / P0 + g
In other words, expected return on investment equals the forward dividend yield (D1 / P0) plus the expected growth rate (g).
A simple formula with few variables, it highlights the importance of cash flows to the investor and the assumed growth rate.
The formula does not work for strong growth stocks, where:
- g is greater than, or equal to k (the infinite geometric progression will not tend towards zero); or
- the stock pays no dividends.
Stocks seldom grow at a constant rate in perpetuity.