Gordon Growth Model

The model is the closed-form solution to a discounted cash flow problem with an infinite horizon. Start with next year's dividend, let it compound at a constant rate forever, and discount every payment at the required return on equity. Because each successive term is the previous one multiplied by the same ratio of one plus growth over one plus the required return, the series is geometric and converges whenever growth is strictly below the required return. Its sum collapses to next year's dividend divided by the spread between the two rates.

That spread does the heavy lifting. When the required return exceeds growth by only one or two percentage points, small revisions to either input swing value enormously, because the denominator is a small number in the divisor. Analysts therefore treat the output as a range rather than a point estimate and routinely present a sensitivity grid over plausible pairs of required return and growth.

Growth is normally anchored in the sustainable growth rate: the retention ratio, meaning one minus the dividend payout ratio, multiplied by return on equity. This ties the growth assumption to the firm's reinvestment policy and profitability rather than to a free-floating guess. A sanity check is the economy itself; a perpetual rate above long-run nominal GDP growth implies the firm eventually becomes the entire economy.

The required return is typically estimated with the capital asset pricing model, adding a beta-scaled equity risk premium to a long-maturity government yield, or via a bond yield plus risk premium approach. Consistency matters: if the dividend stream is stated in nominal terms, the required return must be nominal, and if analysis is done in a foreign currency, both inputs must reflect that currency's inflation environment.

Beyond valuing mature, high-payout businesses such as regulated utilities, consumer staples and large banks, the formula does its most common work as the terminal value inside multistage models. An analyst forecasts explicit dividends through a high-growth and transition phase, then applies the constant-growth formula to the first dividend of the stable phase and discounts that lump sum back to today.

It also produces justified multiples. Dividing both sides by earnings converts the expression into a justified leading price-to-earnings ratio equal to the payout ratio divided by the spread between required return and growth; using trailing earnings adds a factor of one plus growth to the numerator. Run in reverse, market price and a consensus dividend imply the growth rate investors are already paying for, a useful cross-check on optimism embedded in a quote.

Expect to compute value from a stated current dividend, which must first be grown one period forward, and to rearrange the relationship to solve for any single unknown: the required return as dividend yield on next year's dividend plus growth, the implied growth rate, or the implied dividend. You should also be able to derive growth from retention and return on equity, and to move between value and justified price-to-earnings.

Equally important is judgment about applicability. The model suits firms whose dividends track earnings and whose growth is stable and below the required return. It is inappropriate for non-payers, for issuers with erratic or heavily cyclical distributions, and for companies in a temporary growth burst; those cases call for multistage dividend models, free cash flow approaches, or residual income.