You can use the Gordon Growth Model calculator to determine the value of a stock. The model also makes some basic assumptions which I’ll cover below, after the formula.
To start, you can enter the current annual dividend. Then put in the constant dividend growth rate and the required rate of return. After that, all you have to do is click Calculate Stock Price…
Your result will appear here.
Gordon Growth Model Formula
So what’s happening under the hood here? It’s a simple formula with the following variables…
D = Annual Dividend
G = Dividend Growth Rate
K = Required Rate of Return (also known as Discount Rate)
P = Price per Share
The Gordon Growth Model formula first calculates what the dividend would be next year. And that’s D times (1+G). This is the numerator in the equation. And below that you’ll find the required rate of return minus the dividend growth rate (K – G). As a result, you get the estimated price per share.
To simplify the formula you can replace the top part with D1 to show next year’s expected dividend. This formula is also a special case of the Dividend Discount Model (DDM). It assumes constant growth and to see this at work, let’s look at the expanded model…
If you’re seeing this formula for the first time, it might look complex… but it’s a simple process. You can always use my calculator above or once the knowledge sinks in, you can recreate your own and make modifications. Please reach out if you have any questions.
Model Assumptions and Flaws
The Gordon Growth Model assumes steady growth and steady discount rates… but this isn’t realistic. The economy ebbs and flows. Many investment trends are at play. And here’s one big example, the average investor’s required rate of return is much lower today than when interest rates peaked in the 1980s.
To factor in these changes and other assumptions, analysts have gravitated towards Discounted Cash Flow (DCF) models.
The Gordon Growth Model formula also assumes the company will never cease to operate… but with history as a guide, this is a clear flaw. Thousands of companies have gone bankrupt and even the original stocks from the Dow Jones Industrial Average no longer remain in the index.
This flaw keeps some people away from using the model. Although, this downside isn’t as bad as it seems. The model puts less weight on the dividends as they go further into the future…
The example above shows the calculation starting with a $2.00 dividend, a 5% growth rate, and an 8% required rate of return. The first discounted dividend of $1.94 makes up about 2.8% of the total calculated price. Then the next drops to $1.89 which is about 2.7% of the total price. This continues to drop and the one hundredth spot only accounts for 0.2% of the total price.
Big Benefit of a Simple Dividend Discount Model
Experts stray away from the Gordon Growth Model because of its simplicity. But that’s one of the main reasons I still use it – along with fundamental analysis.
Analysts continue to come up with more complicated models. Their confusing stock picking systems are easier to sell to clients. It’s also how they justify higher management fees. Although, active funds underperform the benchmarks they’re trying to beat.
More information isn’t always better. As people take in more information to make a decision, their confidence climbs. Although, the accuracy of the resulting decision doesn’t always follow suit. This is one of six techniques I use to make better decisions and improve my focus.
I hope my Gordon Growth Model calculator helps you along with my explanation. If you have any questions, please reach out. I’d also love to hear any feedback.
P.S. With a few core investing concepts, you can find a faster path to financial freedom.