Gordon Growth Model Formula

Updated on March 22, 2024
Article byWallstreetmojo Team
Edited byWallstreetmojo Team
Reviewed byDheeraj Vaidya, CFA, FRM

What Is Gordon Growth Model Formula?

The Gordon growth model formula refers to the expression used to calculate the intrinsic value of the stocks of a company. It is computed by discounting the future dividend payouts of the company and helps in assessing the relation between the constant dividend growth and the share prices of the company

You are free to use this image on your website, templates, etc, Please provide us with an attribution linkHow to Provide Attribution?Article Link to be Hyperlinked
For eg:
Source: Gordon Growth Model Formula (wallstreetmojo.com)

The formula lets users calculate the approximate value of the price of a company’s share. It is one form of the Dividend Discount Model (DDM), which calculates the stock price based on the probable dividends one would pay.

Key Takeaways

  • The Gordon Growth Model formula determines the company’s intrinsic Value by discounting the future dividend company payouts.
  • The first component is the estimated dividends for the next period. One must look at the historical data and the past growth rate to find the estimated dividends.
  • Moreover, one can also take help from financial analysts and projections. Though the estimated dividends are inaccurate, they may forecast something closer to future dividends.
  • The second component of the formula has two parts – the growth rate and the required rate of return.

Gordon Growth Model Formula Explained

Gordon Growth Model Formula works in two ways. While one form of the expression helps figure out the constant growth in future dividends, another lets users learn about zero growth in future dividends.

#1 – Constant Growth in Future Dividends

The Gordon growth model formula with the constant growth rate in future dividends is below.

First, let us have a look at the formula: –

P0 = Div1/(r-g)

Here,

  • P0 = Stock price
  • Div1= Estimated dividends for the next period
  • r = Required Rate of Return
  • g = Growth rate
Financial Modeling & Valuation Courses Bundle (25+ Hours Video Series)

–>> If you want to learn Financial Modeling & Valuation professionally , then do check this ​Financial Modeling & Valuation Course Bundle​ (25+ hours of video tutorials with step by step McDonald’s Financial Model). Unlock the art of financial modeling and valuation with a comprehensive course covering McDonald’s forecast methodologies, advanced valuation techniques, and financial statements.

Video Explanation of Gordon Growth Model

 

Explanation

In the above formula, we have two different components.

The first component of the formula is the estimated dividends for the next period. To determine the estimated dividends, you need to look at the historical data and the past growth rate. You can also take help from financial analysts and the projections they make. Of course, the estimated dividends would not be accurate, but the idea is to predict something closer to the actual future dividends.

The second component has two parts – the growth rate and the required rate of return.

To find out the growth rate, we need to use the following formula –

Growth Rate = Retention Ratio * ROE

As you already know, if we divide the retained earningsRetained EarningsRetained Earnings are defined as the cumulative earnings earned by the company till the date after adjusting for the distribution of the dividend or the other distributions to the investors of the company. It is shown as the part of owner’s equity in the liability side of the balance sheet of the company.read more by net income, we would get the retention ratioRetention RatioRetention ratio indicates the percentage of a company’s earnings which is not paid out as dividends but credited back as retained earnings. This ratio highlights how much of the profit is being retained as profits towards the development of the firm.read more, or else, we can also use (1 – Dividend Payout RatioDividend Payout RatioThe dividend payout ratio is the ratio between the total amount of dividends paid (preferred and normal dividend) to the company's net income. Formula = Dividends/Net Incomeread more) to find out the retention ratio.

And ROE is the return on equity ROE Is The Return On EquityReturn on Equity (ROE) represents financial performance of a company. It is calculated as the net income divided by the shareholders equity. ROE signifies the efficiency in which the company is using assets to make profit.read more (net income/shareholders’ equity)

To find out the required rate of return, we can use the following formula –

r = (D / P0) + g

In other terms, we can find requires the rate of returnRequire The Rate Of ReturnRequired Rate of Return (RRR), also known as Hurdle Rate, is the minimum capital amount or return that an investor expects to receive from an investment. It is determined by, Required Rate of Return = (Expected Dividend Payment/Existing Stock Price) + Dividend Growth Rateread more just by adding a dividend yield and the growth rate.

#2 –Zero Growth in Future Dividends

The only difference in this formula is the “Growth factor.”

Here is the formula –

Stock - PV with Zero Growth Formula

Here, P = Price of the Stock; r = required rate of return

Explanation

This formula is based on the dividend discount modelThe Dividend Discount ModelThe Dividend Discount Model (DDM) is a method of calculating the stock price based on the likely dividends that will be paid and discounting them at the expected yearly rate. In other words, it is used to value stocks based on the future dividends' net present value.read more.

Thus, we place the estimated dividends in the numerator and the required rate of return in the denominator.

We will skip the growth factor since we are calculating with zero growth. And as a result, the required rate of return would be the discounting rate. So, for example, if we assume that a company would pay $100 as a dividend in the next period, and the required rate of return is 10%, then the stock price would be $1,000.

We should keep in mind while calculating the formula the period we use for the calculation. The period of the dividends should be similar to the period of the required rate of return.

So, if you consider the annual dividends, you need also to take the required annual rate of return to maintain the integrity of the calculation. To calculate the required rate of return, we will consider dividend yieldDividend YieldDividend yield ratio is the ratio of a company's current dividend to its current share price.  It represents the potential return on investment for a given stock.read more into consideration (r = Dividends / Price).  (r = Dividends / Price). And we can find out by using historical data. The required rate of return is the minimum rate the investors would accept.

Calculation Examples

Let us consider the following examples to understand the calculation:

Example 1 – Gordon Growth Model For Constant Growth

You can download this Gordon Zero Growth Rate template Excel here – Gordon Zero Growth Rate template Excel

Hi-Fi Company has the following information –

  • Estimated dividends for the next period – $40,000
  • The required rate of return – 8%
  • Growth rate – 4%

Find out the stock price of Hi-Fi Company.

We know the estimated dividends, growth rate, and required return rate in the above example.

By using the stock – PV with constant growth formula, we get –

  • P0 = Div1 / (r – g)
  • Or, P0 = $40,000 / (8% – 4%)
  • Or, P0 = $40,000 / 4%
  • Or, P0 = $40,000 * 100/4 = $10, 00,000.

Using the above formula, we can find out the present stock price. It can be an excellent tool for investors and the management of any company. We should notice that the stock price is the total stock price since we assumed the estimated dividends for all the shareholders. By simply taking the number of shares into account, we could determine the stock price per share.

Gordon Growth Model Calculator

You can use the following Stock – PV with Constant Growth Calculator.

Div1
r
g
PO =
 

PO =
Div1
=
(r − g)
0
= 0
(00)

Example 2 – Gordon Growth Model For Zero Growth

Let us take an example to illustrate the Gordon growth model formula with a zero growth rate.

Big Brothers Inc. has the following information for every investor –

  • The estimated dividends for the next period – $50,000
  • The required rate of return – 10%

Find out the price of the stock.

By using the Stock – PV with Zero Growth Formula, we get –

  • P = Dividend / r
  • Or, P = $50,000 / 10% = $500,000.
  • The stock price would $500,000.

You should notice that $500,000 is the total market price of the stock. And depending on the number of outstanding shares, we would find out the price per share. 

In this case, let us say that the outstanding sharesOutstanding SharesOutstanding shares are the stocks available with the company's shareholders at a given point of time after excluding the shares that the entity had repurchased. It is shown as a part of the owner's equity in the liability side of the company's balance sheet.read more is 50,000.

That means the stock price would be = ($500,000 / 50,000) = $10 per share.

Gordon Zero Growth Calculator

You can use the following Gordon Zero Growth Rate Calculator.

First Value
Second Value
Formula =
 

Formula =
First Value
=
Second Value
0
= 0
0

Gordon Zero Growth Formula in Excel

#1. Constant Growth Excel Template

Let us now do the same example above in Excel. It is straightforward. One must provide the three dividends, rate of return, and growth rate inputs.

It is easy to find the company’s stock price in the provided template.

Stock - PV with Constant Growth in Excel

You can download this Gordon Growth Model Formula template here – Gordon Growth Model Formula with Constant Growth Excel Template

#2. Zero Growth  Excel Template

Let us now do the same example above in Excel. That is very simple. You need to provide the two inputs of dividend and rate of return.

You can easily find out the stock price in the template provided. 

Stock - PV with Zero Growth in Excel

Uses

The uses of the two Gordon Growth Models are:

Constant Rate Gordon Growth Model

We will understand the present stock price using this formula. Let’s look at both of the formula components. We will see that we use a similar present valuePresent ValuePresent Value (PV) is the today's value of money you expect to get from future income. It is computed as the sum of future investment returns discounted at a certain rate of return expectation.read more method to determine the stock price.

First, we calculate the estimated dividends. Then, we divide it by the difference between the required rate of return and the growth rate. That means the discounting rate is the difference between the required rate of return and the growth rate. By dividing the same, we can easily find out the present value of the stock price.

Zero Growth

This formula estimates dividends for the next period. And the discounting rate is the required rate of return, i.e., the rate of return that the investors accept. There are various methods of using which investors and financial analysts can find out the present value of the stock, but this formula is the most fundamental.

Thus, before investing in the company, every investor should use this formula to find out the present value of the stock.

Frequently Asked Questions (FAQs)


When to use the Gordon Growth Model formula?

The GGM holds that dividends resolve for an infinite succession of future dividends with present value and grow perpetually. As a result, because the model considers a steady growth rate, it is frequently applied to businesses with stable growth rates in dividends per share.

What does the Gordon Growth Model formula show?

The dividend payments provided to owners of common equity are estimated by the Gordon Growth Model using a constant growth assumption. It supposes that a business will always exist and pay increasing dividends per share.

How does the Gordon Growth Model formula calculate terminal Value?

The Gordon Growth Model formula determines the terminal Value using the formula: Terminal Value = Cashflow to Firm /( Cost of Capital – g ).

Why use the Gordon Growth Model formula?

The Gordon Growth Model tries to find the stock’s fair Value regardless of the prevailing market situations and considers the dividend payout factors and the market anticipated returns.

Recommended Articles

This article is a guide to what is Gordon Growth Model Formula. We explain it with examples, calculations, excel templates, and uses. You may learn more about valuations from the following articles: – 

Reader Interactions

Comments

Leave a Reply

Your email address will not be published. Required fields are marked *