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)
Where:
- 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).
Strengths of the Gordon Growth Model
A simple formula with few variables, it highlights the importance of cash flows to the investor and the assumed growth rate.
Weaknesses of the Gordon Growth Model
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.
Emphasis on Growth
When using Gordon’s Growth Model, I often suspected that it placed too much emphasis on growth and not enough on the current price/yield. I set out to prove this, using the example below, but came to the conclusion that it does not.
Example
Companies A & B produce the same free cash flow of $2.00 per year. A pays $2 in dividends while B pays $1 in dividends and uses the other $1 to buy back shares or make acquisitions. The investment of $1 per year is 1% of market capitalization and generates 1% of additional growth if B earns a similar return on new and existing investment.
- Company A has a dividend yield of 2% and an expected growth rate of 10%
- Company B has a dividend yield of 1% and expected growth of 11%
Using Gordon’s Growth Model we arrive at an expected investment return of 12% for both stocks (yield plus growth). A and B would have the same value.
If the investments made by Company B produce more than 1% additional growth then it will offer a higher investment return than A and most likely attract a higher value.
For the sake of simplicity I have ignored tax implications of the different actions (buybacks or investment versus dividends) but these could also affect the relative attractiveness of the two stocks.