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Gordon Growth Model (GGM): Definition, Formula, Calculation, Pros & Cons
The Gordon Growth Model (GGM) - a variation of the Dividend Discount Model (DDM) - calculates a stock's intrinsic value. It is useful for companies with stable growth because the model assumes that dividends increase at a constant rate and will always be paid out.
QUOTE
I do not own a single security anywhere that doesn't pay a dividend, and I formed a mutual-fund company with that very simple philosophy.
Big ideas
- The GGM is a simple model to find the intrinsic value of a stock. However, investors should know when to use it and when to prefer other methods of stock valuation.
- The GGM is suitable for large companies with stable growth as gauged by the dividends per share (DPS). It works for mature companies that have limited risk and volatility.
- To understand the GGM, it is necessary to understand the dividend discount model (DDM).
What is the Gordon Growth Model (GGM)?
Created in the 1960s by economist Myron J. Gordon, the GGM model tells an investor what to pay today (the intrinsic value) for a dividend-paying stock. A big point to make is that it does not apply to non-dividend-paying stocks. Like all such models, it gives you this information based on specific assumptions.
The assumptions are that the company will exist forever, that dividends will increase at a constant rate, and that the economic environment will remain stable for the foreseeable future.
Provided that these assumptions hold true, the model is relatively accurate. If the intrinsic value of the stock is higher than the current market value, then it is a buying opportunity as per the GGM model.
Provided that these assumptions hold true, the model is relatively accurate. If the intrinsic value of the stock is higher than the current market value, then it is a buying opportunity as per the GGM model.
Importance of the GGM in stock valuation
GGM plays a key role once its base assumptions are met. It is a simple and effective tool that is easily understood when it comes to finding the intrinsic value of a stock. It is very well-suited to long-term investors who want to invest in stable companies that consistently pay dividends to shareholders.
A dividend is a share of profits paid out to shareholders of a specific stock. Not all companies pay dividends, but most large-cap companies will tend to do so.
Massive companies like Microsoft (MSFT), Meta Platforms (META), Tesla (TSLA), Apple (AAPL), Johnson and Johnson (JNJ), Walmart (WMT), and Coca-Cola (KO) might not exist forever, but it is a reasonable bet they will be around for 50 years and more, which is near the maximum investing lifespan for most individuals. Plus, many companies have a decades-long history of paying dividends to shareholders. The GGM model is widely used by financial analysts, investors, portfolio managers, and other professionals on dividend stocks.
A dividend is a share of profits paid out to shareholders of a specific stock. Not all companies pay dividends, but most large-cap companies will tend to do so.
Massive companies like Microsoft (MSFT), Meta Platforms (META), Tesla (TSLA), Apple (AAPL), Johnson and Johnson (JNJ), Walmart (WMT), and Coca-Cola (KO) might not exist forever, but it is a reasonable bet they will be around for 50 years and more, which is near the maximum investing lifespan for most individuals. Plus, many companies have a decades-long history of paying dividends to shareholders. The GGM model is widely used by financial analysts, investors, portfolio managers, and other professionals on dividend stocks.
How to calculate company value using the GGM?
The GGM model is a simple stock valuation methodology that uses the next period dividend per share (D₁), the dividend growth rate (g), and the rate of return (r). The relationship between these three determines the intrinsic value.
FORMULA
Intrinsic value of a stock = Next period dividend per share / (Required rate of return - Dividend growth rate)
or
P = D₁/ (r - g)
• Next period dividend per share - the DPS is the dividend per outstanding share. In this formula, the next period dividend per share (D₁) is a projection of the expected payout of company dividends in the next period. The current DPS is already known.
• Dividend growth rate - growth rate expected for dividends. This is a constant assumed rate.
• Rate of return - minimum rate of return required by investors as assessed by other market opportunities. This takes the risk of investment into account and can also be termed the discount rate.
or
P = D₁/ (r - g)
• Next period dividend per share - the DPS is the dividend per outstanding share. In this formula, the next period dividend per share (D₁) is a projection of the expected payout of company dividends in the next period. The current DPS is already known.
• Dividend growth rate - growth rate expected for dividends. This is a constant assumed rate.
• Rate of return - minimum rate of return required by investors as assessed by other market opportunities. This takes the risk of investment into account and can also be termed the discount rate.
After the intrinsic value of the stock has been produced, the company can then be declared overvalued or undervalued as per the GGM model. If it is overvalued, then it is not a viable investment, though it could be shorted by advanced traders. If it is undervalued, then it could represent a viable buying opportunity.
Calculating the intrinsic value using GGM
There are four main steps to calculating the intrinsic value using the GGM. These are as follows:
- Estimate the next year's dividends per share (D₁)
- Determine the constant dividend growth rate (g)
- Calculate the required rate of return (r)
- Apply the GGM formula to find the intrinsic value
Calculating the intrinsic value using GGM
The GGM formula is easy to apply. In most instances, DPS, g, and r are already known or very easy to calculate/obtain.
The next period dividend per share (D₁) is calculated by multiplying the DPS x (1 + g). This is the expected dividend payout in the next period.
The next period dividend per share (D₁) is calculated by multiplying the DPS x (1 + g). This is the expected dividend payout in the next period.
EXAMPLE
Assume that a UK company has:
• A current annual dividend (DPS or D₀) of £2.00
• An expected dividend growth rate (g) of 4%
• A required rate of return (r) of 8%
The following two steps can be used to calculate the intrinsic value as per the GGM model.
• D₀ is the current dividend (£2.00)
• D₁ is the expected dividend for the next period (£2.08)
Step 1:
D₁ = D₀ × (1 + g) = £2.00 × (1 + 0.04) = £2.08
Step 2:
P₀ = D₁ / (r - g) = £2.08 / (0.08 - 0.04) = £52
So, using the GGM, the estimated intrinsic value of the UK stock is £52 per share.
Interpretation
The estimated price per share of £52 represents the intrinsic value of the stock based on the Gordon Growth Model and its assumptions.
If the market price of the company is below £52, it suggests the stock may be undervalued, indicating a potential buying opportunity, since it is trading for less than its calculated worth.
If the market price is above £52, the stock may be overvalued, suggesting it might be overpriced relative to its future dividend growth and expected returns.
• A current annual dividend (DPS or D₀) of £2.00
• An expected dividend growth rate (g) of 4%
• A required rate of return (r) of 8%
The following two steps can be used to calculate the intrinsic value as per the GGM model.
• D₀ is the current dividend (£2.00)
• D₁ is the expected dividend for the next period (£2.08)
Step 1:
D₁ = D₀ × (1 + g) = £2.00 × (1 + 0.04) = £2.08
Step 2:
P₀ = D₁ / (r - g) = £2.08 / (0.08 - 0.04) = £52
So, using the GGM, the estimated intrinsic value of the UK stock is £52 per share.
Interpretation
The estimated price per share of £52 represents the intrinsic value of the stock based on the Gordon Growth Model and its assumptions.
If the market price of the company is below £52, it suggests the stock may be undervalued, indicating a potential buying opportunity, since it is trading for less than its calculated worth.
If the market price is above £52, the stock may be overvalued, suggesting it might be overpriced relative to its future dividend growth and expected returns.
Benefits of using the Gordon Growth Model
GGM simplifies the valuation process by using just three variables: dividend, growth rate, and required return. It is particularly helpful for dividend-paying companies, providing a quick benchmark for potential value.
Simplicity, ease of use, and flexibility
With a basic formula, it allows investors to gauge a stock's worth quickly. Its flexibility means it can be adjusted for different growth rates, making it suitable for various scenarios. Despite its simplicity, it offers valuable insights into the potential returns on investment on the basis of value investing.
Clearer investment decisions
By estimating a stock’s intrinsic value, GGM helps investors decide whether a stock is worth buying. It uses dividend growth and expected returns to provide a clearer picture of a stock's potential. This approach makes it easier to filter out stocks that may not meet an investor's return requirements, focusing only on those aligned with their goals.
Considers negative growth
GGM is not limited to positive growth rates. It can also account for companies with declining dividends, providing a more comprehensive valuation. This feature is useful for evaluating mature companies that might experience periods of reduced growth, as long as the decline is steady over time.
Provides a benchmark for investment decisions
GGM offers a clear benchmark for comparing a stock's market price with its calculated value through overvaluation and undervaluation. This comparison helps investors identify potential buy or sell opportunities. By providing a baseline, GGM makes it easier to assess whether a stock is trading at a fair price. This makes it a valuable tool for portfolio management.
Disadvantages and limitations of the GGM
The Gordon Growth Model has its drawbacks. It is simple but lacks the depth needed for complex situations. It assumes a lot about future growth, which is not always realistic. If a company's growth is unpredictable, GGM might give misleading results. Investors should know its limits before using it as a standalone valuation tool.
Sensitivity to growth rate and discount rate
The model is highly sensitive to small changes in the growth rate and discount rate. A slight change in either can significantly alter the calculated value. This can make the results less reliable, especially for companies with fluctuating growth or uncertain future prospects. It works best when both rates are stable and predictable.
Applicable only to companies with stable growth
GGM is designed for companies with stable and consistent dividend growth. It doesn’t suit companies with irregular or no dividend payments. Startups, tech firms, or companies in volatile industries often don't fit this model. If a company's dividends are erratic, GGM's value estimate can be way off.
Assumes linear growth
The model assumes dividends grow at a constant rate forever. In reality, company growth often fluctuates due to market conditions, competition, and other factors. This linear growth assumption can oversimplify the valuation, ignoring the complexities of a company's growth cycle. It is not suitable for companies expecting rapid changes.
Requires growth rate to be lower than the return rate
GGM assumes the growth rate is always lower than the required return rate. If the growth rate is higher, the model doesn’t make sense. This is a major limitation for high-growth companies, where the expected growth can exceed the required return, making the model inapplicable in such cases.
Limited in scope
The GGM only considers dividend payments and growth, ignoring other factors like earnings, cash flow, or market conditions. It focuses solely on dividends, which is not the only way companies return value to shareholders. This narrow scope makes it less useful for companies that reinvest profits instead of paying dividends.
How does the GGM compare to other models such as the DDM and DCF?
The Gordon Growth Model, Dividend Discount Model (DDM), and Discounted Cash Flow (DCF) model are valuation tools used by investors. GGM is a simplified version of the DDM, assuming constant dividend growth.
It calculates the present value of an infinite series of future dividends. This makes it suitable for companies with stable and predictable dividend growth, but less useful for those with erratic dividends.
It calculates the present value of an infinite series of future dividends. This makes it suitable for companies with stable and predictable dividend growth, but less useful for those with erratic dividends.
The DDM is more flexible. While GGM assumes a constant growth rate, the DDM can handle varying growth rates in different periods. It involves forecasting dividends over several periods and discounting them to their present value. This makes the DDM more complex but better suited for companies with varying dividend policies or growth phases.
The DCF model, on the other hand, is broader. Unlike GGM and DDM, which focus on dividends, DCF considers the total cash flows of a company. It discounts these cash flows to determine the company's intrinsic value.
The DCF model is not limited to dividend-paying companies and is used to evaluate companies based on their expected future cash flows, regardless of how they return value to shareholders.
The DCF model, on the other hand, is broader. Unlike GGM and DDM, which focus on dividends, DCF considers the total cash flows of a company. It discounts these cash flows to determine the company's intrinsic value.
The DCF model is not limited to dividend-paying companies and is used to evaluate companies based on their expected future cash flows, regardless of how they return value to shareholders.
Recap of Gordon Growth Model (GGM)
GGM is one of the more straightforward equity valuation models, useful specifically for companies that have a history of dividend payouts and has little applicability elsewhere. It is an easy and quick way for long-term investors to understand whether a stock is overvalued or undervalued.
Just be mindful that some companies will reinvest capital instead of issuing dividends to shareholders. Dividends are not the only way to provide value - the GGM model is quite narrow in its scope, ignoring items like brand loyalty, cash flow, non-tangibles, and many other non-dividend factors.
Just be mindful that some companies will reinvest capital instead of issuing dividends to shareholders. Dividends are not the only way to provide value - the GGM model is quite narrow in its scope, ignoring items like brand loyalty, cash flow, non-tangibles, and many other non-dividend factors.
FAQ on Gordon Growth Model (GGM)
Q: What is the Gordon Growth Model (GGM)?
This Gordon Growth Model (GGM) is a simplified version of the Dividend Discount Model (DDM) that estimates the intrinsic value of a stock based on future dividend payments. Developed in the 1960s by economics professor Myron J. Gordon, the GGM assumes that dividends are expected to grow in perpetuity. This model is best suited for valuing stable, dividend-paying companies with consistent growth. Investors use the GGM to determine if a stock is undervalued or overvalued by comparing its intrinsic value with its current market price.
Q: What is the GGM formula?
The GGM formula is:
P = D₁/ (r - g)
Where:
• P = Intrinsic value of the stock
• D₁ = Expected dividend in the next period
• r = Required rate of return
• g = Dividend growth rate
The model works best for mature companies with steady growth and may not apply to companies with high or irregular growth rates.
P = D₁/ (r - g)
Where:
• P = Intrinsic value of the stock
• D₁ = Expected dividend in the next period
• r = Required rate of return
• g = Dividend growth rate
The model works best for mature companies with steady growth and may not apply to companies with high or irregular growth rates.
Q: What is GGM used for?
The Gordon Growth Model is used to estimate the intrinsic value of a stock based on its future dividends. It is especially useful for companies with stable and predictable dividend growth. By focusing on dividends, GGM helps investors decide whether a stock is overvalued or undervalued compared to its market price. It simplifies the process of stock valuation.
Q: Is GGM a DDM?
Yes, GGM is a type of Dividend Discount Model (DDM). While DDM can accommodate different growth rates and periods, GGM specifically assumes a constant growth rate for dividends. It simplifies the DDM by focusing on companies with stable, predictable growth. In essence, GGM is a simplified version of the broader DDM framework, designed for specific situations.
Q: How does the GGM relate to the DCF?
The Discounted Cash Flow model and the Gordon Growth Model both aim to find a company's intrinsic value. DCF values a company based on all expected future cash flows, discounting them to the present. GGM is a simplified DCF variant focusing only on dividends, assuming constant growth. While DCF applies to any cash flow, GGM is specific to stable, dividend-paying companies.
Q: What is the terminal value of the GGM?
The terminal value in the Gordon Growth Model is the estimated value of all future dividends beyond a certain point, assuming they grow at a constant rate. It is just another way of saying the company's value. This value represents the stock's price, assuming perpetual growth at a steady rate. It is key to estimating a company’s long-term value. GGM is only one way of calculating the terminal value.
Q: What is the 3 dividend model?
The 3 Dividend Model is not a standard term in valuation. It may refer to the Dividend Discount Model with three growth phases: high initial growth, a transition period, and stable long-term growth. In this setup, dividends are projected for each phase, and the present value of these dividends is calculated. This approach suits companies with varying growth rates over time.
