The Gordon growth model is one of the first valuation formulas Level I candidates learn, and one of the first they feel comfortable with. Value equals dividend divided by the required return minus growth. It looks impossible to get wrong.
It is not. The formula needs next period's dividend, D1. Questions often give you the dividend just paid, D0. Plug D0 straight in and your answer is off by exactly one year of growth, which is exactly the kind of number a distractor is built from.
Using D0 where D1 is required is one of the most reliable ways to lose points in equity valuation. The subscript is small. The cost is not.
Why the Model Prices Next Period's Dividend
The value of a share today is the present value of the dividends its owner will receive. That word, "will", is the whole logic.
D0 is the dividend that was just paid. It belongs to whoever owned the share before it went ex-dividend. A buyer today does not receive it, so it cannot be part of today's value. The first cash flow the buyer can expect is D1, one period from now.
If dividends grow at a constant rate g forever and the required return r exceeds g, the stream D1, D1 × (1 + g), D1 × (1 + g)², and so on is a growing perpetuity. Its present value simplifies to:
V0 = D1 / (r - g)
The numerator is forward-looking because the valuation is forward-looking. This is a core concept, not a notational convention. The general form makes it explicit: the value at any time n uses the dividend one period later, Vn = Dn+1 / (r - g).
The Conversion: D1 = D0 × (1 + g)
When the question gives the dividend just paid, grow it by one period before doing anything else:
D1 = D0 × (1 + g)
When the question already gives next year's dividend, use it as it is. Do not grow it again. This second error is the mirror image of the first, and it catches candidates who learned "always multiply by (1 + g)" as a rule instead of reading the timeline.
The same logic sits behind justified price multiples. The leading P/E divides price by next year's earnings, the trailing P/E by the last year's, and the trailing version carries an extra (1 + g) in its numerator for exactly this reason.
Worked Example: The Right Answer and the Distractor
Illustrative question: a company just paid an annual dividend of $2.00. Dividends are expected to grow at 4% a year indefinitely, and the required return on equity is 9%. What is the value of the share today?
Correct approach. "Just paid" means the $2.00 is D0.
- D1 = $2.00 × 1.04 = $2.08
- V0 = $2.08 / (0.09 - 0.04) = $2.08 / 0.05 = $41.60
The D0 distractor. Plugging $2.00 directly into the numerator gives $2.00 / 0.05 = $40.00. It is clean, round and plausible. It is also wrong by exactly one year of growth: $40.00 × 1.04 = $41.60.
Now change one phrase. If the company will pay a dividend of $2.00 next year, the $2.00 is D1 and the value is $40.00. The candidate who grows it anyway gets $2.08 / 0.05 = $41.60, the mirror-image distractor. The same two numbers appear in both versions, and only the wording tells you which is right.
The error travels into later valuation dates. Valuing the share at the end of year 3 requires D4, not D3: D4 = $2.00 × 1.04⁴ ≈ $2.3397, so V3 ≈ $2.3397 / 0.05 ≈ $46.79. As a check, V3 should equal V0 × 1.04³, and $41.60 × 1.04³ ≈ $46.79.
The Gordon growth model is not tested on algebra. It is tested on timing.
Question-Wording Cues
The subscript is almost never written in the question. You have to infer it from the wording.
| Wording | What you have | What to do |
|---|---|---|
| "just paid", "most recent dividend", "last year's dividend" | D0 | Multiply by (1 + g) first |
| "will pay next year", "next dividend", "expected dividend for the coming year" | D1 | Use it directly |
"Expected" deserves care. "The dividend expected to be paid next year" is D1. "Dividends are expected to grow at 4%" tells you nothing about which dividend you have been given. Read the sentence that contains the dollar amount, not the one that contains the word "expected".
Harder versions move the dividend out of the obvious place: into an exhibit, a footnote or a sentence about the company's payout history. Do not confuse where the number appears with when it is paid. Identify the valuation date first, then find the first dividend after it.
The Habit: Draw the Timeline Before Touching the Calculator
The reliable fix is not another rule to memorize. It is a ten-second habit: draw a short timeline, mark today as time 0, and place every dividend the question gives you on it.
Once the $2.00 sits at time 0 or time 1, the rest is mechanical. The model always needs the dividend one period after the valuation date. If it is not there yet, grow it forward. If it is already there, leave it alone.
The habit costs seconds and removes the distractor entirely. It also transfers to multistage dividend models, bond pricing and annuity problems, where the underlying question is always the same: when does each cash flow arrive? The same discipline is the core of time value of money.
Precision on small details is not a talent. It is a habit, built by working every dividend question the same way until the timeline is automatic.