Gordon model: Meaning, Criticisms & Real-World Uses

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What Is Gordon Model?

The Gordon model, also known as the Gordon Growth Model (GGM), is a quantitative method used in valuation to determine a stock's intrinsic value based on the assumption that its dividends will grow at a constant rate indefinitely³⁰. This model is a widely used tool within equity valuation, a sub-category of corporate finance, and posits that the true worth of a stock is the present value of all its future dividend payments²⁹. The Gordon model is particularly suited for valuing mature, dividend-paying companies with stable and predictable dividend growth²⁸.

History and Origin

The Gordon Growth Model was developed by Myron J. Gordon, a Canadian economist, in collaboration with Eli Shapiro, and was first published in 1956. Gordon made further references to it in 1959 and 1962²⁷. Their work built upon the theoretical and mathematical foundations laid by John Burr Williams' 1938 book, "The Theory of Investment Value," which had introduced the dividend discount model (DDM) years earlier. The Gordon model emerged in contrast to the dividend irrelevance theory proposed by Miller and Modigliani in 1958, which suggested that a firm's stock price is independent of its dividend policy once its investment policy is set²⁶.

Key Takeaways

The Gordon model estimates a stock's intrinsic value by discounting its expected future dividends.
It assumes that dividends will grow at a constant rate in perpetuity.
The model is most applicable to mature companies with stable dividend payment histories.
It is a simplified version of the broader Dividend Discount Model.
The Gordon model can help investors determine if a stock is undervalued or overvalued compared to its market price.

Formula and Calculation

The formula for the Gordon model is expressed as:

P_0 = \frac{D_1}{r - g}

Where:

( P_0 ) = Current stock price or intrinsic value
( D_1 ) = Expected dividend per share in the next period
( r ) = Required Rate of Return (also known as Cost of Equity)
( g ) = Constant dividend growth rate in perpetuity

The formula essentially calculates the present value of a growing perpetuity of dividends²⁵. The expected dividend for the next period (( D_1 )) can be calculated by taking the current dividend (( D_0 )) and multiplying it by (1 + g).

Interpreting the Gordon Model

The result of the Gordon model calculation represents the estimated intrinsic value of a stock. Investors interpret this value by comparing it to the current market price of the stock²⁴. If the intrinsic value derived from the Gordon model is higher than the current market price, the stock might be considered undervalued and a potential buying opportunity. Conversely, if the intrinsic value is lower than the market price, the stock may be considered overvalued²³. It's crucial that the required rate of return (( r )) is greater than the dividend growth rate (( g )); otherwise, the formula yields a negative or infinite value, rendering it unusable²².

Hypothetical Example

Consider Company XYZ, a mature company with a consistent dividend history. Its most recent annual dividend per share (( D_0 )) was $2.00. Investors expect this dividend to grow at a constant rate of 3% per year (( g )). The required rate of return (( r )) for investing in Company XYZ's stock is 8%.

First, calculate the expected dividend for the next period (( D_1 )):
( D_1 = D_0 \times (1 + g) = $2.00 \times (1 + 0.03) = $2.06 )

Now, apply the Gordon model formula:
( P_0 = \frac{D_1}{r - g} = \frac{$2.06}{0.08 - 0.03} = \frac{$2.06}{0.05} = $41.20 )

According to the Gordon model, the intrinsic value of Company XYZ's stock is $41.20. If the current market price of Company XYZ's stock is, for example, $38.00, the model suggests it might be undervalued.

Practical Applications

The Gordon model is widely used in financial analysis, particularly for its simplicity in determining the intrinsic value of stable, dividend-paying companies²⁰, ²¹. Investment analysts often employ it to gauge whether an equity is fairly valued or to assess potential investment decisions ¹⁹. For instance, a common application is in evaluating utility companies or established consumer staple businesses, which typically have predictable cash flows and consistent dividend policies¹⁸.

While generally suited for mature companies, the Gordon model can also be incorporated into more complex valuation methods, such as multi-stage dividend discount models ¹⁷. In these models, the Gordon model might be used to estimate the terminal value of dividends in a stable growth phase following an initial period of higher, variable growth¹⁶.

For example, a study by analysts at Universidade Católica Portuguesa examined the accuracy of the Gordon's growth model on US stocks, comparing its valuations with observed market prices. Their findings suggested that the model might not be an accurate tool for valuing US companies in the twenty-first century, showing a growing underestimation tendency during the analyzed period (2002-2018), which could lead to incorrect investment decisions.
¹⁵

Limitations and Criticisms

Despite its widespread use, the Gordon model has several significant limitations. A primary criticism is its core assumption of a constant dividend growth rate in perpetuity. In reality, very few companies can maintain a perfectly constant dividend growth rate indefinitely, as business cycles and economic conditions often lead to fluctuating dividend payments.¹⁴ This makes the model less reliable for companies with erratic dividend histories or those in early growth stages that might reinvest profits rather than distribute them as dividends.

Another major drawback is the model's sensitivity to its inputs, particularly the dividend growth rate (( g )) and the required rate of return (( r )).¹³ Even minor changes in these variables can lead to substantial differences in the calculated intrinsic value, highlighting the "garbage in, garbage out" problem.¹² Furthermore, the model becomes unusable if the required rate of return is equal to or less than the dividend growth rate, as it would result in an infinite or negative stock price, which is economically illogical.¹¹ The Gordon model also does not account for non-dividend factors that can contribute to a company's value, such as brand loyalty or intangible assets.

Gordon Model vs. Dividend Discount Model

The Gordon model is often considered a specific, simplified version of the broader Dividend Discount Model (DDM).¹⁰ Both models aim to calculate the intrinsic value of a stock based on the present value of its future dividend payments.⁹ The key difference lies in their assumptions regarding dividend growth.

The Gordon model assumes a constant and perpetual growth rate for dividends.⁸ This makes it suitable for valuing mature companies with stable dividend policies.⁷ In contrast, the more general Dividend Discount Model is more flexible, allowing for varying dividend growth rates over different periods, such as a period of high growth followed by a more stable, lower growth phase. While the Gordon model offers simplicity, the DDM can accommodate more complex and realistic dividend patterns, making it applicable to a wider range of companies, including those with fluctuating dividend payout ratios.⁶

FAQs

What is the primary assumption of the Gordon Model?
The primary assumption of the Gordon model is that a company's dividend payments will grow at a constant rate indefinitely into the future.⁵

Can the Gordon Model be used for all types of stocks?
No, the Gordon model is best suited for valuing mature, stable companies that pay consistent dividends and are expected to continue doing so with a predictable growth rate.⁴ It is generally not appropriate for growth stocks that do not pay dividends or have highly irregular dividend payments.

What happens if the required rate of return is less than the dividend growth rate in the Gordon Model?
If the required rate of return is less than or equal to the dividend growth rate, the Gordon model produces a negative or infinite value, rendering it invalid for valuation purposes. This condition implies that the company's growth is unsustainable in the long run given the investor's required return.

How does the Gordon Model relate to Discounted Cash Flow?
The Gordon model is a simplified form of a Discounted Cash Flow (DCF) model, specifically tailored for companies that distribute a significant portion of their earnings as dividends.³ While a general DCF model discounts all expected future cash flows (e.g., free cash flow to firm or equity), the Gordon model focuses specifically on dividends as the relevant cash flow to shareholders.²

What are the key inputs needed for the Gordon Model?
The key inputs for the Gordon model are the expected dividend per share for the next period, the constant dividend growth rate, and the required rate of return (or cost of equity).¹