The Gordon growth model is particularly appropriate for valuing the equity of dividend-paying companies that are relatively insensitive to the business cycle and in a mature growth phase.
where g is the constant growth rate.
If required return r is assumed to be strictly greater than growth rate g, then the square-bracketed term is an infinite geometric series and sums to [(1 + g)/(r – g)]:
In estimating a long-term growth rate, analysts use a variety of methods, including assessing the growth in dividends or earnings over time,
g = b × ROE
where
- g = dividend growth rate
- b = earnings retention rate = (1 – Dividend payout ratio)
- ROE = return on equity
The assumptions of the Gordon model are as follows:
- Dividends are the correct metric to use for valuation purposes.
- The dividend growth rate is forever: It is perpetual and never changes.
- The required rate of return is also constant over time.
- The dividend growth rate is strictly less than the required rate of return.
An analyst might be dissatisfied with these assumptions for many reasons. The equities being examined might not currently pay a dividend. The Gordon assumptions might be too simplistic to reflect the characteristics of the companies being evaluated. Some alternatives to using the Gordon model are as follows:
- Use a more robust DDM that allows for varying patterns of growth.
- Use a cash flow measure other than dividends for valuation purposes.
- Use some other approach (such as a multiplier method) to valuation.
