what is the gordon growth model ggm 
the gordon growth model ggm is a formula 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 investopedia xiaojie liugordon growth model formulathe gordon growth model formula is based on the mathematical properties of an infinite series of numbers growing at a constant rate the three key inputs in the model are dividends per share dps the growth rate in dividends per share and the required rate of return ror p d 1 r g where p current stock price g constant growth rate expected for dividends in perpetuity r constant cost of equity capital for the company or rate of return d 1 value of next year s dividends begin aligned p frac d 1 r g textbf where p text current stock price g text constant growth rate expected for text dividends in perpetuity r text constant cost of equity capital for the text company or rate of return d 1 text value of next year s dividends end aligned p r gd1 where p current stock priceg constant growth rate expected fordividends in perpetuityr constant cost of equity capital for thecompany or rate of return d1 value of next year s dividends source stern school of business new york university 1importance of the gordon growth modelthe ggm attempts to calculate the fair value of a stock irrespective of the prevailing market conditions and takes into consideration the dividend payout factors and the market s expected returns if the value obtained from the model is higher than the current trading price of shares then the stock is considered to be undervalued and qualifies for a buy and vice versa dividends per share represent the annual payments a company makes to its common equity shareholders while the growth rate in dividends per share is how much the rate of dividends per share increases from one year to another the required rate of return is the minimum rate of return investors are willing to accept when buying a company s stock and there are multiple models investors use to estimate this rate assumptions of the gordon growth modelthe gordon growth model values a company s stock using an assumption of constant growth in dividend payments that a company makes to its common equity shareholders the ggm assumes that a company exists forever and pays dividends per share that increase at a constant rate to estimate the intrinsic value of a stock the model takes the infinite series of dividends per share and discounts them back to the present using the required rate of return 2limitations of the gordon growth modelthe main limitation of the gordon growth model lies in its assumption of constant growth in dividends per share it is very rare for companies to show constant growth in their dividends due to business cycles and unexpected financial difficulties or successes the model is thus limited to firms showing stable growth rates the second issue occurs with the relationship between the discount factor and the growth rate used in the model if the required rate of return is less than the growth rate of dividends per share the result is a negative value rendering the model worthless also if the required rate of return is the same as the growth rate the value per share approaches infinity 1the gordon growth model can only be used to value companies that regularly issue dividends it may be less reliable for growth stocks since these companies tend to reinvest their profits rather than distributing them to shareholders example of the gordon growth modelas a hypothetical example consider a company whose stock is trading at 110 per share this company requires an 8 minimum rate of return r and will pay a 3 dividend per share next year d1 which is expected to increase by 5 annually g the intrinsic value p of the stock is calculated as follows p 3 08 05 100 begin aligned text p frac 3 08 05 100 end aligned p 08 05 3 100 according to the gordon growth model the shares are currently 10 overvalued in the market advantages and disadvantages of the gordon growth modelggm is a simple and straightforward way to establish the intrinsic value of a stock allows comparison between companies of different sizes and industries 