The Gordon Growth Model (GGM) is a method for calculating the intrinsic value of a stock based on a future series of dividends that grow at a constant rate. Often used by value investors, this model helps determine if a stock is currently undervalued or overvalued relative to its dividend-paying potential.
This article will help you learn the GGM formula and how to interpret its inputs.
Key Takeaways
- The Gordon Growth Model (GGM) estimates a stock's theoretical fair value based on projected perpetual dividend payments.
- Calculation requires three primary inputs: expected next-year dividend, required return, and constant growth rate.
- The model applies strictly to mature companies with stable dividend histories; it does not produce valid results for non-dividend payers or high-growth firms.
- GGM outputs serve as a baseline for comparison against market prices, requiring investors to separately verify dividend sustainability and input assumptions.
What is the Gordon Growth Model?
The Gordon Growth Model, named after economist Myron J. Gordon, assumes that dividends grow at a constant rate indefinitely. By applying this constant growth rate, the present value of all expected future cash flows (dividends) is calculated.
What is the Gordon Growth Model Formula?
The formula for the Gordon Growth Model is:
P₀ = D₁ / (r − g)
Where:
- P₀ = Current intrinsic value of the stock
- D₁ = Expected dividend per share for the next year (D₁ = D₀ * (1 + g))
- r = Required rate of return (the minimum return an investor demands for the risk taken).
- g = Constant dividend growth rate (expected to continue indefinitely).
The formula only works if the required rate of return exceeds the expected dividend growth rate.
Example:
An investor who wants a 10% return and expects dividends to grow at 4% per year has a spread of 6%. This difference is a denominator of the GGM formula.
| Parameter / Step | Value / Details |
| Expected Dividend (D1) | ₹5 per share |
| Required Rate of Return (r) | 10% (0.10) |
| Dividend Growth Rate (g) | 4% (0.04) |
| Calculation Formula | P0 = D1 / (r - g) |
| Calculation Step | P0 = 5 / (0.10 - 0.04) = 5 / 0.06 |
| Calculated Intrinsic Value (P0) | ₹83.33 |
| Market Price Comparison: Undervalued | If trading at ₹70, the stock is undervalued. |
| Market Price Comparison: Overvalued | If trading at ₹100, the stock is overvalued. |
Importance of the GGM in Stock Valuation
- Valuation simplicity: The Gordon Growth Model is a straightforward, effective tool for estimating a stock's intrinsic value when its underlying assumptions hold, making it a foundational tool for long-term dividend evaluation.
- Focus on cash distributions: Dividends represent a direct share of company profits paid out to shareholders, a practice typical of established large-cap corporations rather than early-stage growth firms.
- Long-term reliability: Blue-chip enterprises have decades-long histories of steady payouts and multi-decade staying power that closely align with individual long-term investment horizons.
Calculating the Intrinsic Value Using GGM
Calculating the intrinsic value using the Gordon Growth Model is straightforward. In most instances, the required variables (DPS, g, and r) are readily available or easy to compute.
Here are the 4 main steps to calculate intrinsic value using the GGM:
Step 1: Estimate Next Year's Dividends per Share (D1)
The next period dividend per share (D1) represents the expected dividend payout for the upcoming period. If you already know the current dividend (D0), you can calculate D1 using the following formula:
D1 = D0 * (1 + g)
Step 2: Determine the Constant Dividend Growth Rate (g)
Identify the expected annual rate at which the company's dividends will grow perpetually. This rate should be realistic and aligned with long-term economic and industry trends, since the model assumes it remains constant over time.
Step 3: Calculate the Required Rate of Return (r)
Determine the minimum rate of return (r) that you, as an investor, demand for taking on the risk of investing in the stock. When calculating the required rate of return, the baseline risk-free rate is typically derived from sovereign debt yields, such as 10-year Government of India (GoI) bonds monitored by the Reserve Bank of India (RBI).
Step 4: Apply the GGM Formula to Find the Intrinsic Value
Plug your variables into the GGM formula to determine the stock's estimated fair value:
P0 = D1 / (r - g)
Once you have calculated P0, you can compare this intrinsic value against the stock's current market price to assess whether it is undervalued or overvalued.
Using the Gordon Growth Model to Determine Terminal Value in Multi-Stage DCF
In a multi-stage Discounted Cash Flow (DCF) model, explicit cash flow forecasts typically cover a discrete period of 5 to 10 years. A viable business generates cash flows well beyond this explicit forecast window; you estimate the Terminal Value (TV), the total present value of all future cash flows from the end of the explicit forecast period into perpetuity.
The Gordon Growth Model (Perpetual Growth Method) assumes that the company’s free cash flows will grow at a stable, constant rate indefinitely once the business reaches maturity.
The Terminal Value Formula
The perpetual Terminal Value is calculated using the final year’s projected Free Cash Flow to Firm (FCFF) or Free Cash Flow to Equity (FCFE):
Terminal Valuen = FCFn+1 ⁄ (WACC − g) = FCFn × (1 + g) ⁄ (WACC − g)
Where:
- FCFn: Free Cash Flow generated in the final year of the discrete forecast period (Year n)
- FCFn+1: Normalized Free Cash Flow expected in the first year of the terminal period
- WACC: Weighted Average Cost of Capital (the required rate of return / discount rate)
- g: Long-term sustainable perpetual growth rate
Key Modeling Assumptions and Constraints
- The g < WACC Condition: The perpetual growth rate must strictly remain lower than the discount rate (g < WACC), or the denominator turns negative, resulting in an impossible or infinite valuation.
- Benchmark against Long-Term GDP: The perpetual growth rate (g) cannot exceed the long-term nominal GDP growth rate of the economy in which the business operates (typically 2%–3% in mature markets). If a company grew faster than the broader economy forever, it would eventually become larger than the global economy. For multinationals with meaningful exposure to faster-growing emerging markets, a slightly higher blended g can sometimes be defensible — but it should be explicitly justified rather than defaulted to.
- Normalized Terminal Cash Flows: Ensure that capital expenditures (CapEx), depreciation, and working capital requirements are normalized in Year n+1. In perpetuity, reinvestment rates must reflect a mature, steady-state enterprise rather than a high-growth phase.
- FCFF vs. FCFE Consistency: The discount rate must match the cash flow type. FCFF is discounted at WACC (giving Enterprise Value). FCFE is discounted at the Cost of Equity, not WACC (giving Equity Value directly). Mixing these produces an internally inconsistent valuation.
Practical Example
Assume a 5-year explicit forecast model with the following parameters:
- Year 5 FCFF (FCF5): ₹100 crore
- WACC: 10.0% (0.10)
- Perpetual Growth Rate (g): 2.5% (0.025)
Step 1 — Project Year 6 FCF
FCF6 = ₹100 × (1 + 0.025) = ₹102.5 crore
Step 2 — Calculate Terminal Value at Year 5
Terminal Value5 = 102.5 ⁄ (0.10 − 0.025) = 102.5 ⁄ 0.075 = ₹1,366.67 crore
Step 3 — Discount Terminal Value back to Present Value (Year 0)
This ₹1,366.67 crore is expressed in Year-5 rupees, not Year-0 rupees, so it is not yet part of Enterprise Value. It must be discounted using the 5-year discount factor:
PV(Terminal Value5) = 1,366.67 ⁄ (1.10)5 = 1,366.67 ⁄ 1.61051 ≈ ₹848.6 crore
This ₹848.6 crore figure is what gets added to the sum of discounted explicit-period FCFs to arrive at total Enterprise Value.
Key Assumptions of the Gordon Growth Model
- Constant Dividend Growth: An assumption is that dividends grow at a constant rate forever. The truth is that companies don’t maintain the same dividend growth rate forever. Dividend payments are influenced by business cycles, competition, economic conditions, and changes in profitability.
- Permanent Dividend Payments: The model assumes the company will continue to pay dividends forever. This makes it inapplicable to companies that do not pay dividends or have highly uncertain dividend policies.
- Required Return Exceeds Growth: The dividend must grow at a rate less than the required rate of return. If r = g, the denominator becomes zero, and the model cannot produce a meaningful valuation. If g > r, the formula gives an economically absurd result. Therefore, the relationship between these two inputs is important.
Advantages and Limitations of The Gordon Growth Model
| Advantages | Limitations |
| Simplicity: Requires only three easy-to-find inputs. | Constant Growth Assumption: Rarely true in real-world market cycles. |
| Long-term Focus: Encourages disciplined, value-oriented investing. | Not for Growth Stocks: Inapplicable to firms that reinvest all earnings. |
| Benchmarking: Helps compare fair value across dividend-paying sectors. | Sensitivity: Minor changes in r or g cause large valuation swings. |
Gordon Growth Model and Dividend Discount Model
The connection: The Gordon Growth Model (GGM) is indeed just a special, simplified version (a single-stage model) of the broader Dividend Discount Model (DDM).
The difference: A multi-stage DDM lets you forecast changing growth phases, such as a startup or high-growth firm experiencing rapid initial expansion before levelling off.
The GGM trade-off: GGM simplifies the calculation by assuming the company has already reached a steady, perpetual state of maturity, making it ideal exclusively for stable, predictable firms.
What Investors Learn From the Gordon Growth Model?
The GGM estimates a stock's value based on its expected dividend stream and the investor’s required return.
When the calculated intrinsic value exceeds the current market price, the model may suggest the stock is undervalued. If the calculated value is lower than the market price, it may appear overvalued.
But the result must always be read in conjunction with the assumptions. A stock may look cheap just because an unrealistic dividend growth rate has been inserted into the formula. The quality of the valuation depends not only on the formula, but also on the quality of the data.
