The Gordon Growth Model is a financial model that uses the cash flow of a company’s projected dividends to arrive at the company’s stock value.
Sounds simple enough, but like any model, the Gordon Growth has assumptions built in. It works well in some circumstances but not in others. Learn how the model works, when it’s useful, and what its limitations are.
Definition and Examples of the Gordon Growth Model
There are two ways you can go about valuing a stock. You can use a relative valuation to other stocks, similarly to the way you would value your home using comparables. The other option is absolute valuation: using cash flow to value a stock irrespective of market conditions. The Gordon Growth model is a type of absolute valuation that calculates a company’s value based on the cash flow of a company’s projected dividends
The formula for the Gordon Growth model is easy to use:
Share price = Expected annual dividend/(Required rate of return - Expected dividend growth rate forever)
If the share price based on the formula is higher than the market price the stock is undervalued, and vice versa.
For example, Company XYZ has a share price of $15.53. After you run the Gordon Growth calculation, you believe the stock is worth $16.37, so you buy shares.
How the Gordon Growth Model Works
The equation for the Gordon Growth Model has three parts: expected annual dividend, discount rate, and expected dividend growth rate.
A stock’s expected annual dividend is the dividend amount that the company is expected to pay out one year from now. The expected dividend growth rate is calculated by using the following equation: (1 - Payout ratio)(Return on equity).
You can find the expected annual dividend and the dividend growth rate for any public company on your broker-dealer’s website.
The required rate of return is the return that you expect as an investor. Your expectations can be different depending on the risk of the investment, and how long your time horizon is. As an individual investor, it would be reasonable to use the average return of the stock market over your investing time horizon as the discount rate.
Let’s see how this works using the XYZ company as an example:
- Expected dividend per share in 2021: $6.56
- Expected dividend growth based on 2014-2020: 7.35%
- Expected rate of return: 14.34%
Using the Gordon Growth Model, the projected share price for XYZ is $93.85 ($6.56/[14.34% - 7.35%]). Since XYZ currently trades for $135.23, the model says the stock is overvalued.
Keep in mind that the model is only as good as the number we input. Suppose we change our expected rate of return to 10.00%. Your valuation for the stock would be $247.54, which means it’s trading well below its value. Keeping that rate of return but adjusting the dividend growth rate to 1.6% would result in a valuation of $78.10 per share, which would make the stock significantly overvalued.
The changes that we made to our example show that the model is very sensitive to discount and dividend growth rate assumptions, and can produce very different results.
Limitations of the Gordon Growth Model
The Gordon Growth Model only applies to a very limited set of companies. The model assumes that the company has a stable business, a steady rate of growth, and will continue to pay dividends each year, growing at a constant rate. The most important limitation however is that the model assumes all free cash flow is paid out as a dividend. While some top dividend-paying companies payout close to 100% of free cash flow, most companies don’t. Companies that fit the profile for Gordon Growth modeling include:
- Real estate investment trusts: Have to pay out 90% of earnings as dividends and are limited in the types of investments they can make
- Utilities: Highly regulated, stable models, and typically are high dividend payers.
- Financial service companies: Highly regulated, and typically are high dividend payers
Alternatives to the Gordon Growth Model
A variation of the Gordon Growth model uses free-cash-flows-to-equity (FCFE) instead of dividends to value share price. FCFE is what is available to pay dividends, and fund stock buybacks. While companies may have different reasons for not paying out 100% of free cash flow as dividends, the free cash flow itself is an objective measure of performance.
Here’s what the model would look like for XYZ using $9 per share of free cash flow with a 6% rate of growth, and a discount rate of the average 50 year S&P of 12.18%:
- $9/(12.18%-6%) = $145.63
If XYZ is currently trading at $135.23, the model indicates the stock is undervalued.
What It Means for Individual Investors
The Gordon Growth model is easy to use and can give investors valuable insight into a company’s fair market value if it fits the profile. Using the free cash flow variation may be a better measure for companies that don’t pay dividends or pay substantially less than 100% of free cash flow.
The model, however, is only one way to look at a company. Using other types of analysis can produce very different results. Professional portfolio managers use multiple metrics to evaluate investments and make their decisions. If you are doing your own research, you may want to consider using more than one model.
- The Gordon Growth Model uses dividends and a constant growth rate to value a company’s stock.
- The model is very sensitive to changes to the discount and dividend growth rates
- The model is only useful for mature companies with a stable business, dividend history, and dividend growth rate.