Gordon Growth Model

The Gordon Growth Model (GGM), also known as the Constant Growth Dividend Discount Model, is a classic tool for estimating a stock's Intrinsic Value. Imagine a company as a goose that lays golden eggs (Dividends). The GGM doesn't just count today's egg; it tries to calculate the value of the goose itself by considering all the eggs it will lay in the future, forever. The model’s core assumption is that these golden eggs will get slightly bigger each year at a steady, Constant Growth Rate. It then takes this endless stream of future dividends and discounts them back to what they're worth in today's money, using an investor's Required Rate of Return. Developed by Myron J. Gordon and Eli Shapiro in the 1950s, it’s a specific and widely used variant of the broader Dividend Discount Model. While its simplicity is its charm, its assumptions are also its biggest weakness, making it most suitable for very stable, predictable businesses.

At its heart, the GGM is a beautifully simple formula. It looks like this: P = D1 / (k - g) Let's break down what each part means. Don't worry, it's more intuitive than it looks!

• P (Price): This is the result you're solving for—the theoretical intrinsic value per share of the company's stock.
• D1 (Dividend in Year One): This isn't last year's dividend, but the expected dividend per share one year from now. You calculate it by taking the most recent annual dividend (D0) and growing it by the growth rate (g). The formula is: D1 = D0 x (1 + g).
• k (Required Rate of Return): This is the minimum annual return an investor demands to justify the risk of owning the stock. It's also known as the Cost of Equity. This is a personal number; a conservative investor might demand a 12% return, while another might be happy with 8% for the same stock. It reflects your compensation for taking a risk.
• g (Constant Growth Rate): This is the rate at which you expect the company's dividends to grow, forever. This is the model's most powerful and dangerous assumption.

Let's put the GGM to work. Imagine you're looking at “Global Utilities PLC,” a fictional, rock-solid utility company.

1. Step 1: Gather your inputs.
   • Global Utilities just paid an annual dividend of $3.00 per share (this is D0).
   • You research the company and believe it can sustainably grow its dividend by 4% per year (this is g).
   • Given the company's stability, you decide your required rate of return is 9% (this is k).
2. Step 2: Calculate D1.
   • You need the dividend for next year.
   • D1 = $3.00 x (1 + 0.04) = $3.12
3. Step 3: Plug everything into the formula.
   • P = $3.12 / (0.09 - 0.04)
   • P = $3.12 / 0.05
   • P = $62.40

According to your GGM analysis, the intrinsic value of Global Utilities PLC is $62.40 per share. A Value Investing practitioner would then compare this to its current market price. If it's trading at $50, it might be a bargain. If it's at $75, it looks overvalued.

The GGM is a double-edged sword. Its simplicity is a great strength but also a source of significant weakness.

• Easy to Use: The formula is incredibly straightforward. It provides a quick, “back-of-the-envelope” valuation with just three key inputs.
• Clear Logic: It directly connects a company's value to the cash it pays its owners. This aligns perfectly with the value investor's mindset of buying a business, not just a ticker symbol.
• Great for Stability: The model is tailor-made for mature companies with long, predictable histories of dividend payments, such as utilities, consumer staples, or certain Blue-Chip Stocks.
• Calculates Terminal Value: In more complex, multi-stage valuation models, the GGM is often used to calculate a company's Terminal Value—its worth from a certain point forward into perpetuity, after it has settled into a stable growth phase.

• Constant Growth is a Myth: The core assumption of a single, perpetual growth rate is the model's Achilles' heel. No company grows at the same pace forever. Economic cycles, competition, and innovation ensure that.
• Highly Sensitive Inputs: The model's output is extremely sensitive to small changes in 'k' and 'g'. A tiny tweak of 0.5% in either input can drastically alter the final valuation. This means you must be very confident in your assumptions. A good practice is to perform a Sensitivity Analysis to see how the value changes with different inputs.
• Useless for Many Companies: The model is completely unsuitable for companies that don't pay dividends (like many tech or growth stocks) or for those with erratic earnings and dividend histories.
• The k > g Rule: The model only works if the required rate of return (k) is greater than the growth rate (g). If g is higher than k, the denominator becomes negative, giving you a meaningless result and mathematically implying infinite value.

The Gordon Growth Model is a fundamental concept every investor should understand, but it should be handled with care. Think of it as a valuable compass, not a flawless GPS. It provides a direction for a company's value but not a precise, guaranteed coordinate. A smart investor uses the GGM as one tool in a comprehensive toolkit. The real insight comes not from the final number it produces, but from the disciplined thinking it requires. It forces you to critically question a company's long-term growth prospects (g) and the risk you are taking on (k). For a value investor analyzing a stable business within their Circle of Competence, the GGM is an excellent first check. Just remember its limitations and always maintain a healthy dose of skepticism about the future.