How do I use the Gordon Growth Model to value a stock? It seems too simple to actually work.

The Gordon Growth Model (GGM) is the simplest form of the dividend discount model, and while it has limitations, it's a cornerstone of equity valuation.

The Formula:

V₀ = D₁ / (r - g)

Where:

• V₀ = Intrinsic value today
• D₁ = Expected dividend next year = D₀ x (1 + g)
• r = Required rate of return
• g = Constant dividend growth rate (must be < r)

Worked Example:

Crestview Pharmaceuticals just paid a dividend of $2.40 (D₀). Dividends are expected to grow at 4% indefinitely. The required return is 10%.

• D₁ = $2.40 x 1.04 = $2.496
• V₀ = $2.496 / (0.10 - 0.04) = $2.496 / 0.06 = $41.60

If Crestview trades at $38, it's undervalued by this model.

When GGM works well:

• Mature, stable companies with predictable dividend growth (utilities, consumer staples)
• Companies with long dividend histories and consistent payout ratios
• Large-cap blue chips with established business models

When GGM breaks down:

1. g >= r: The formula produces a negative or infinite value — mathematically impossible for a finite-value asset
2. Non-dividend-paying companies: No dividends means D₁ = 0, so V₀ = 0 (obviously wrong for tech companies)
3. Cyclical companies: Growth is far from constant
4. High-growth companies: A 25% growth rate won't persist forever, violating the "constant" assumption

Sensitivity analysis:

Small changes in g dramatically affect the valuation:

A 1% change in growth from 4% to 5% increases value by 20%! This sensitivity is the model's biggest practical weakness.

For non-constant growth, use the multi-stage DDM:

Forecast dividends individually for high-growth years, then apply GGM to the stable phase terminal value.

Exam tip: The CFA exam often provides g very close to r to test whether you recognize the model becomes unreliable when the denominator is small.

Practice DDM calculations in our CFA Level I question bank.