What Is the Dividend Discount Model (the Gordon Growth Model)
How can you calculate a stock's 'fair value'? One of the most classic answers is 'add up all the dividends you will receive going forward, discounted to present value.'
The Idea Behind the Dividend Discount Model (DDM)
The Dividend Discount Model (DDM) values a stock as 'the sum of the present values of all dividends you will receive going forward.'
Because future money is worth less than money today (discounting), the further in the future a dividend is, the smaller its present value. The sum of the present values of all these dividends is, in theory, the stock's price.
In other words, it asks 'how much is the cash (dividends) this stock will give me over its lifetime worth right now?'
The Gordon Growth Model: P = D1 / (r - g)
Adding up infinite dividends one by one is difficult. So the Gordon growth model simplifies things by assuming dividends grow at a constant rate (g) each year (Myron Gordon, 1950s).
The formula is P = D1 / (r - g).
- P = the stock's theoretical value - D1 = the dividend expected to be received next year - r = the required rate of return (the return you demand) - g = the annual growth rate of the dividend
For example, if next year's dividend is $10, the required return is 8%, and the dividend growth rate is 3%, then P = 10 / (0.08 - 0.03) = $200.
Source: CFA Institute 'Discounted Dividend Valuation,' Wall Street Prep 'Gordon Growth Model.' The formula holds only under the assumption that growth is constant.
A Fatal Constraint: r Must Be Greater Than g
The Gordon growth model has a condition that must be observed: the required return r must be greater than the growth rate g (r > g).
If g equals or exceeds r, the denominator (r - g) becomes zero or negative, and the result becomes infinite or negative — an economically meaningless value.
The model is also highly sensitive to g. Changing g even slightly swings the result greatly. So plugging in an excessively high growth rate can inflate the value unrealistically.
In conclusion, the DDM is excellent 'as a tool for understanding the concept,' but it fits poorly for companies that pay no dividends or have erratic growth rates, and you must always remember the limit that the result changes greatly with the inputs.
This article does not present a target price or trade for any specific stock. It is for educational purposes, explaining the model's mechanics and limits.
Frequently Asked Questions
Q. Do you value companies that pay no dividends with this model too?
If there is no dividend, the Gordon growth model is hard to use as is. In such cases, other methods such as free-cash-flow-based models (DCF) are used together.
Q. Plugging in a high growth rate (g) raises the value — can I set it however I like?
No. Raising g close to r inflates the result unrealistically or drives it to infinity. g must be smaller than r and should be set conservatively at a sustainable level.
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