Gordon Growth Model

The model calculates a share's value by dividing next year's expected dividend by the difference between the required rate of return and the dividend growth rate.

Suppose a company is expected to pay a dividend of 2.10 next year, investors require a return of 9% and dividends are expected to grow by 4% a year forever. The share's value is 2.10 divided by 5%, which is 42.

The model shows clearly how value depends on growth and required return. If the growth rate rises to 5%, the value increases to 52.50. If the required return rises to 10%, the value falls to 35.

The model only works if the growth rate is lower than the required return; otherwise the result is meaningless. It is also very sensitive to the inputs when the two rates are close together. Because it assumes growth continues at the same rate forever, it suits mature, stable companies best. The same formula is used in discounted cash flow models to estimate terminal value, where it is called the perpetual growth method.