# Gordon Growth Model

What is the Gordon Growth Model?

Gordon Growth Model (GGM), the most used variant of the Dividend Discount Model (DDM), is a valuation method that is used to calculate the intrinsic value (IV) of a stock. It is most commonly used as part of discounted cash flow (DCF) analysis, where it is used as an alternative to the exit multiple method of determining the terminal value (TV).

This model uses three inputs, i.e., expected dividend per share, the required rate of return, and the growth rate of dividend. It is named after Myron J. Gordon, who invented this method of valuing stocks along with Eli Shapiro.

^{Myron Gordon - Source: The Globe and Mail}

## Gordon Growth Model: Inputs

The Gordon Growth Model (GGM) is a simple and easy-to-use method to value stocks. Its appeal lies in the fact that all of its inputs are relatively easy to calculate or estimate and that it complies with basic logic. It is a variant of the Dividend Discount Model, which equates the present value of a stock to the total of all its discounted future dividend income.

Hence, GGM requires three inputs which are all related to the dividend payments. Below is a brief description of each one:

**Expected dividend per share**

The GGM requires the expected dividend per share to be received one year into the future as a starting point. If only the current year's dividend per share is available, the expected dividend at the end of next year can be calculated as.**Current dividend x (1 + Growth rate of dividend)****Growth rate of dividend**

The growth rate of dividends is a key input used in GGM and relates to the growth rate of dividend receipts. A mistake that newcomers to the topic frequently make is that of using the entity's growth rate instead of the growth rate of dividends.

Since small changes to this variable can bring about big changes in the valuation, it is important to calculate and use a rate that is as close to reality as possible. There are two ways to calculate growth rate; by using historical data, or by using forecasted data.

The historical method of calculating growth rate is very straightforward. It involves selecting a historical period that is most likely to match the future performance of the company, and then calculating the growth rate of dividends over that period.

The other method used quite frequently in current times is the forecasted growth rate. This involves assuming that the dividend is paid out at a certain percentage of net income to the company. Its financial statements are then forecasted into the future, which in turn gives us the forecasted net income of the company. The growth rate can then be calculated easily using the assumption that dividends will be paid out at a certain percentage of net income throughout the period being analyzed.**The required rate of return**

The required rate of return, also known as the "cost of equity", is the minimum rate of return required by investors to invest in the shares of the company and varies from investor to investor. Assuming no individual bias, this rate can be deduced by looking at the risk-return profiles of similarly sized companies employing similar levels of leverage.

## Gordon Growth Model: Formula

The formula for calculating the intrinsic value of a stock using the Gordon Growth Model (GGM) is:

Intrinsic value = D1 / (k - g)

where,

D1 = Expected dividend in year 1 (next year)

k = Required rate of return / cost of equity

g = Growth rate of dividend

Let's now see this formula in action using an example.

Chimps Ltd. has an EPS of $0.56 and pays out a dividend of $0.15 today. Looking at the past results of Chimps Ltd., Analyst X has calculated the growth rate of EPS to be 10% and of dividend to be 8%. Due to the high leverage used by Chimps Ltd., the required rate of return is 16%.

Plugging these values into the GGM formula leaves us with a valuation of $1.875 ($0.15 / (16% - 8%)) per share. In this example, we have intentionally provided details regarding Chimp Ltd.'s EPS to drive home the point that only dividend is to be used and not EPS.

[H2] Gordon Growth Model: Assumptions

The Gordon Growth Model (GGM) is a very simple method to value the stock of a company as it relies on assumptions that limit most of the factors requiring judgment. However, to use the ratio appropriately and to the fullest, it is better to understand the assumptions that underlie the model as this helps to address any shortcomings of the model in real-life applications. Assumptions used as part of GGM are:

- The company's future dividend per share payments grows at a constant rate
- The company continues to grow forever
- The required rate of return is greater than the rate of growth
- The required rate of return remains constant forever
- The company's capital structure remains constant in the future
- The company does not withhold any free cash flows (FCF), thereby paying all FCF to shareholders as dividends

## Gordon Growth Model: Drawback and limitations

Looking at the assumptions underlying the Gordon Growth Model (GGM), we see that using such a simplistic model comes with its own set of assumptions that may not be realistic. Let's look at a few drawbacks and limitations of the GGM:

**Assumes constant growth in dividend payments**

No company has been able to achieve a constant growth rate. Almost every company goes through the business lifecycle (Startup, Growth, Maturity, Decline) each stage of which has different growth characteristics. This assumption, however, matches the ones used while calculating the terminal value in the discounted cash flow (DCF) method of valuation where we assume constant growth over the foreseeable future. Hence, this use case is where it is most commonly used.**Cannot be used where the expected growth rate is higher than the required rate of return**

While valuing high-growth companies, the growth rates tend to be higher than the required rate of return. Using this in the GGM leads to companies having negative valuations, which in real life is an unlikely scenario. Hence, this formula may not be useful while valuing early-stage companies.**Cannot be used to value companies that do not pay out any dividends**

Since the model assumes that all FCF will be paid out in the form of dividends, it cannot be applied while valuing companies that pay low or no dividends to their shareholders. An example of a company that does not pay any dividends is Warren Buffett's Berkshire Hathaway. Another important point to consider is that since most companies choose not to distribute all available free cash flow (FCF) (this is because most companies use internally generated cash flow as a source of funds for future investments), using the GGM would lead to undervaluing most of them, to the extent they don't distribute the FCFs.**Companies change their capital structure based on the market environment**

GGM assumes that the rate of leverage used by a company is fixed forever. This however is not realistic, as capital structure varies from time to time. For example, in an environment of low interest rates (at the time of writing this article, late 2021, low-interest rates have been prevalent for more than a year), companies tend to raise debt capital instead of equity, and vice versa. Hence, it is not appropriate to assume a constant level of leverage employed while valuing any company.

## Gordon Growth Model vs Dividend Discount Model

The dividend discount model (DDM) assumes that the intrinsic value of a share is equal to the total value of its dividend payments, discounted to the present. Since Gordon Growth Model (GGM) is a simplified version of the dividend discount model, the two terms are frequently used interchangeably. The purpose of this section is to highlight the differences between the two to make sure that you understand which term and model to use under which circumstances.

Since GGM is a simplified version of the dividend discount model, it suffers from more drawbacks as compared to the DDM. For example, to value a company with a high growth rate in the initial stage such as startups, one can use a multi-stage dividend model to address the varying levels of growth across the lifecycle of the company, while this is not possible while using the GGM due its assumption of constant growth rate.

Another limitation that the dividend discount model addresses are that of varying required rates of return in the future. While using GGM assumes a constant rate of return for all future periods, the multi-stage DDM can accommodate varying required rates of return over different periods.

A key point to keep in mind is that the dividend discount model provides more flexibility as compared to the GGM and hence can be made to fit many multiperiod assumptions. Hence, when time and simplicity are of the essence, using GGM over the dividend discount model may be better when accuracy and detail are more important, DDM is more relevant than GGM.

## Gordon Growth Model: When to use it?

Gordon Growth Model (GGM) assumes a constant rate of future growth which generally matches the characteristics of mature companies. Hence, the valuation of companies in the maturity stage of their lifecycle is one of the best applications of GGM.

Another use case that assumes constant growth into the future is the calculation of terminal value as part of the discounted cash flow method of valuation. While this is the most common application of GGM, it is important to note that GGM must only be used when the company being valued fits the assumptions underlying GGM. Otherwise, it may be better to use the exit multiple method of calculating terminal value.

Also, using GGM requires you to make a constant trade-off between time and complexity. Hence it is always useful to keep in mind which among those two is more important with GGM favoring time and DDM favoring complexity and accuracy.

Below is a video from our Valuation Modeling Course that explains the difference between intrinsic and relative valuation.

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