Gordon Growth Model
The Gordon Growth Model is a simplified version of the dividend discount model that values a stock based on next year's expected dividend divided by the difference between the required rate of return and the assumed constant dividend growth rate.
Developed by economist Myron Gordon and Eli Shapiro in the 1950s, the Gordon Growth Model — also called the constant-growth DDM — provides a single closed-form equation for stock valuation when dividends are expected to grow at a stable, perpetual rate. The elegance of the formula has made it a foundational tool in equity valuation courses and a useful sanity-check framework even for practitioners who rely primarily on more complex multi-stage models.
The formula is: P = D1 / (r − g), where P is the intrinsic value per share, D1 is the dividend expected at the end of the next period, r is the investor's required rate of return, and g is the perpetual dividend growth rate. If Johnson & Johnson is expected to pay a $5.00 annual dividend next year, the required return is 9%, and dividends are expected to grow at 4% per year indefinitely, the Gordon Growth Model would value the stock at $5.00 / (0.09 − 0.04) = $100. If the stock trades at $90, it would appear to trade below intrinsic value; at $115, it would appear overvalued.
Rearranging the formula yields important insights. The earnings yield implied by the model (D1/P) plus the growth rate (g) equals the required return (r). This formulation is sometimes called the 'expected return decomposition': investors in a dividend-paying stock can expect their total return to come from two sources — the current dividend yield and the rate at which dividends (and presumably the share price) grow over time. This aligns with the intuition that the total return on a stable dividend-growth stock like Coca-Cola or Realty Income is the sum of its yield and its growth.
The model's limitations are significant and must be understood. First, it is extremely sensitive to the spread between r and g. If those two inputs are close together — say r = 7% and g = 5% — a small forecast error doubles or halves the implied value. Second, and more fundamentally, the assumption of constant perpetual growth is unrealistic for most companies. No firm can grow its dividends faster than the economy indefinitely. The model works best for mature, slow-growing companies in stable industries where near-perpetual growth at a modest rate is genuinely plausible.
For high-growth companies that currently pay little or no dividend, or for firms undergoing significant business model transitions, the Gordon Growth Model should be used only as a rough benchmark. Multi-stage DDM models, or discounted free cash flow models using terminal value assumptions, are more appropriate in those cases. That said, even experienced analysts use the Gordon Growth Model to derive an implied cost of equity from current market prices by solving for r given observable P and D1 and an assumed g — a technique that helps calibrate the risk premium embedded in valuations across different sectors.