Constant-Growth Model

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Constant-Growth Model

The most widely cited dividend valuation approach, the constant-growth model, assumes that dividends will grow at a constant rate, but a rate that is less than the required return. The constant-growth model is commonly called the Gordon model.

The Gordon Growth Model – otherwise described as the dividend discount model – is a stock valuation method that calculates a stock’s intrinsic value. Therefore, this method disregards current market conditions. Investors can then compare companies against other industries using this simplified model.

The Gordon Growth Model (GGM) is used to determine the intrinsic value of a stock based on a future series of dividends that grow at a constant rate. It is a popular and straightforward variant of the dividend discount model (DDM). The GGM assumes that dividends grow at a constant rate in perpetuity and solves for the present value of the infinite series of future dividends. Because the model assumes a constant growth rate, it is generally only used for companies with stable growth rates in dividends per share.

Key Points:

  • Gordon Growth Model (GGM) assumes that a company exists forever and that there is a constant growth in dividends when valuing a company's stock.
  • GGM takes the infinite series of dividends per share and discounts them back into the present using the required rate of return.
  • GGM is a variant of the dividend discount model (DDM).
  • GGM is ideal for companies with steady growth rates given its assumption of constant dividend growth.
Importance of Constant Growth Model:

The Gordon Growth Model can be used to determine the relationship between growth rates, discount rates, and valuation. Despite the sensitivity of valuation to the shifts in the discount rate, the model still demonstrates a clear relation between valuation and return. It’s also important to note that the Gordon Growth Model (GGM for short) only assumes that the growth rate is constant. And as a consequence, one can only use it for firms whose dividends per share has a stable growth rate.

The Gordon Growth Model Formula:

This model has a formula, and so it relies on figures to produce a prediction for a certain period. The prediction one can give with regards to this formula must be based on the outcome of the calculation.

Below is the GGM’s formula, including what each term stands for:

P = D1 / r-g

P = the letter P indicates the current stock price of the company of interest.

D1 = Next year’s dividend’s value

r = the company’s consistent cost of equity capital

g = Constant growth rate, which is expected for dividends, in perpetuity.

To illustrate, take a look at the following example:

                                                                         Company A’s is listed at $40 per share. Furthermore, Company A requires a rate of return of 10%. Currently, Company A pays dividends of $2 per share for the following year which investors expect to grow 4% annually. Thus, the stock value can be computed:

Intrinsic Value = 2 / (0.1 – 0.04)

Intrinsic Value = $33.33

This result indicates that Company A’s stock is overvalued since the model suggests that the stock is only worth $33.33 per share.


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