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Home > Asset Management Checklists > Applying the Gordon Growth Model

Asset Management Checklists

Applying the Gordon Growth Model


Checklist Description

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

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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 ÷ RG

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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.

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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.

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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 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 programs 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.

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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

  • Don’t use the model for companies, industries, or market indices where growth rates are rapid or leverage is subject to sudden swings.

  • Don’t make the mistake of blindly applying the model to companies in isolation.

  • Don’t totally ignore nonquantitative factors that could have a major bearing on future valuations.

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Further reading

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. 3rd ed. Hoboken, NJ: Wiley, 2011.

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. Online at: dx.doi.org/10.1086/422629

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