Applying the Gordon Growth Model

Checklist Description
This checklist examines the Gordon growth model, its principal applications, and its main strengths and
weaknesses.

Definition
The Gordon growth model is a tool that is commonly used to value stocks. Originally developed by Professor
Myron Gordon and also known as Gordon’s growth model, the aim of the method is to value a stock or
company in today’s terms, using discounted cash flows to take into account the present value of future
dividends.
The model requires three inputs:
• D: The expected level of the stock’s dividend one year ahead
• R: The rate of return the investor is seeking
• G: The assumed constant rate of future dividend growth in perpetuity.
The formula is as follows:
Gordon growth stock valuation per share = D ÷ R # G

Advantages
• The main strength of the Gordon growth model is that the valuation calculation is easily performed
using readily available or easily estimated inputs.
• The model is particularly useful among companies or industries where cash flows are typically strong
and relatively stable, and where leverage patterns are also generally consistent.
• The model is widely used to provide guideline fair values in mature industries such as financial services
and in large-scale real-estate ventures. The model can be particularly appropriate in the valuation of
real-estate investment trusts, given the high proportion of income paid out in dividends and the trusts’
strictly defined investment policies.

Disadvantages
• Although the model’s simplicity can be regarded as one of its major strengths, in another sense this
is its major drawback, as the purely quantitative model takes no account of qualitative factors such
as industry trends or management strategy. For example, even in a highly cash-generative company,
near-future dividend payouts could be capped by management’s strategy of retaining cash to fund a
likely future investment. The simplicity of the model affords no flexibility to take into account projected
changes in the rate of future dividend growth.
• The calculation relies on the assumption that future dividends will grow at a constant rate in perpetuity,
taking no account of the possibility that rapid near-term growth could be offset by slower growth further
into the future. This limitation makes the Gordon growth model less suitable for use in rapidly growing
industries with less predictable dividend patterns, such as software or mobile telecommunications.
Its use is typically more appropriate in relatively mature industries or stock-market indices where
companies demonstrate more stable and predictable dividend growth patterns.

Action Checklist
• The Gordon growth model is generally more effective among companies and industries where dividend
payments tend to be high—ideally, close to free cash flow to equity (FCFE). FCFE is a measure of

Applying the Gordon Growth Model 1 of 3

www.qfinance.com
 how much cash a company can afford to pay out to shareholders after allowing for factors such as
debt repayments and various expenses. Consider whether the entity to be valued exhibits such high
dividend payments before making use of the model.
• Take into account other company-specific factors before applying the model to particular stocks. For
example, consider how changes to the regulatory environment could affect a company’s prospects.
• In the case of individual company valuations, consider whether a shift in the management’s
geographical horizon or major investment programmes could affect cash flow and future dividend
patterns. Remember that the Gordon growth model does not take into account possible fluctuations in
future dividend growth rates.

Dos and Don’ts

Do
• Understand the underlying characteristics of the company, industry, or market index before deciding
whether to use this model.
• If appropriate, use the model for easily calculated outline valuations.
• Consider the benefits of using other valuation tools in conjunction with or as alternatives to the Gordon
growth model.

Don’t
• Use the model for companies, industries or market indices where growth rates are rapid or leverage is
subject to sudden swings.
• Make the mistake of blindly applying the model to companies in isolation.
• Totally ignore non-quantitative factors that could have a major bearing on future valuations.

More Info
Books:
• Gordon, Myron J. The Investment, Financing, and Valuation of the Corporation. Westport, CT:
Greenwood Press, 1982.
• Hitchner, James R. Financial Valuation: Applications and Models. 2nd ed. Hoboken, NJ: Wiley, 2006.

Articles:
• Jackson, Marcus. “The Gordon growth model and the income approach to value.” Appraisal Journal
62:1 (Spring 1994): 124–128.
• Kiley, Michael T. “Stock prices and fundamentals: A macroeconomic perspective.” Journal of Business
77:4 (October 2004): 909–936. dx.doi.org/10.1086/422629

Website:
• Myron J. Gordon’s homepage: www.rotman.utoronto.ca/~gordon

See Also
Best Practice
• Dividend Policy: Maximizing Shareholder Value
• Valuation and Project Selection When the Market and Face Value of Dividends Differ
Checklists
• Using Dividend Discount Models
• Using Multistage Dividend Discount Models
Calculations

Applying the Gordon Growth Model 2 of 3

www.qfinance.com
 • Discounted Cash Flow
Finance Library
• Damodaran on Valuation: Security Analysis for Investment and Corporate Finance

(Metadata)
Unknown element essaypdateorig

To see this article on-line, please visit

http://www.qfinance.com/investment-management-checklists/applying-the-gordon-growth-model

Applying the Gordon Growth Model 3 of 3

www.qfinance.com