Gordon Growth Model: One Valuation Model for Your Investor Tool Belt
Arguably the most important questions an investor must ask is: “How much is the stock actually worth?” There are many methods to answer this question. One popular method is the Gordon Growth Model.
Myron Gordon came up with the Gordon Growth Model in 1956. The model is a variation of the Dividend Discount Model. The Dividend Discount Model came about from the 1938 book “The Theory of Investment Value” written by John Burr Williams.
Both Models say that stocks get their value from the dividends that companies pay to shareholders. Specifically, the present value of future dividends can tell you how much the stock is worth today.
The difference between the two models is the growth rate of the future dividends. Specifically, the Gordon Growth Model assumes future dividends grow at a constant rate. Let’s dig in further.
A Closer Look At The Gordon Growth Model Formula
The Gordon Growth Model Formula contains the four variables listed below.
- P: This is the estimated value of the stock today based on the Gordon Growth Model.
- D1: This is the dividend paid by the company at the end of the investment period. Typically, one year.
- r: This is the cost of equity of the company. Investors can estimate the cost of equity in many ways. Investors commonly use CAPM. Others may use the company’s ROE, the 10-year treasury yield, or even their own desired rate of return for the stock.
- g: This is the assumed growth rate of the dividend. The Gordon Growth Model assumes this rate remains constant forever.
Taking a step back, the Gordon Growth Model formula looks like this: P = D1/(r-g). Remember that r and g are used in the formula in decimal form, not whole percentages.
A Gordon Growth Model Example
Let’s say you’re interested in buying shares of JPMorgan Chase (JPM). Then you ask yourself how much the shares are worth (or P in the Gordon Growth Formula). After that, you see that JPMorgan Chase’s stock is about $154 per share. Also, you can see that JP Morgan pays an annual dividend of $4.
Next, you estimate r and g. You decide to use JPMorgan Chase’s ROE to estimate r. JP Morgan Chase has an ROE of 18%. You also find that JPMorgan Chase has grown its dividend by 15% over the last five years. When you put those numbers into the Gordon Growth Model, you get:
- $133 = $4 / (.18-.15)
You might decide that JPMorgan Chase stock is a bit higher than its value from your assessment. Meaning it is expensive or overvalued by the market.
Advantages and Disadvantages
Many valuation methods are based on theory. The Gordon Growth Model is no exception. The model has its pluses and minuses.
Reasons the model makes sense:
- Dividends are cash paid by the company to stockholders. There is no doubt that cash dividends are valuable to investors.
- In addition, a stock’s price can go up and down over time. The Gordon Growth Model can help investors understand the value of a stock. Understanding the value of a stock can be helpful when stock prices rise or fall dramatically. Knowing the value of a stock can allow investors to take advantage of swings in the price instead of being afraid of them.
Reasons the model might not make sense:
- The model assumes that dividends grow at a constant rate forever. A company can change its dividend at any time. If a company increases its dividend faster than you predicted in your formula, the calculation of P will increase. If the company decreases or eliminates the dividend, the value will decrease.
- Estimating r can take many forms. Different investors may calculate completely different values for r. If you use CAPM to evaluate r, additional estimations are needed. Various estimates for r can lead to very different implied values for P.
- Stocks can derive value from growth in earnings. The Gordon Growth Model ignores value derived from growth in earnings.
When Should You Use The Gordon Growth Model Formula?
The Gordon Growth Model only works for companies that pay a dividend. So, it will work best for companies committed to paying dividends in the future. In addition, investors valuing companies that have a consistent estimation for r will also benefit from using the model.
On the other hand, many companies are focused on growing the company’s earnings. Many of these companies don’t pay a dividend. These companies will typically use cash to invest in the company itself instead of paying it to shareholders. Even if these companies do pay a dividend, the Gordon Growth Model might not indicate the stock’s actual value.
If you’re interested in a stock focused on growing earnings, other valuation methods might be more appropriate. For instance, the discounted cash flow or price-to-earnings methods might give you a better sense of value.
About BJ Cook
BJ Cook is a long-time stock nerd. He has held several roles in the equity research world and earned the right to use the CFA designation in 2014. When he’s not writing for Investment U, you can find him searching for new investment ideas. Outside the investment community, BJ is a die-hard Cubs fan.