In this article, I will show you how to apply the Gordon Growth Model (GGM) for dividend discount valuation. Named after American economist Myron J. Gordon, who popularized the model in the 1960s, the GGM is used to estimate the intrinsic value of a stock. It calculates the present value of a future series of dividends expected to grow at a constant rate indefinitely. This article will explore the formula of the model, delve into its underlying assumptions, identify scenarios where it is most effectively applied, discuss its limitations in determining intrinsic value, and, finally, offer a comprehensive example illustrating how to calculate and interpret the GGM in dividend discount valuations.

Gordon Growth Model (GGM) Formula

The essence of the Gordon Growth Model (GGM) lies in its ability to estimate the present value of a company based on future dividends, assuming that dividends grow at a constant rate indefinitely. This simple yet powerful concept has made the GGM a staple in the realm of finance, offering a fundamental approach to stock valuations, especially useful for mature, dividend-paying companies.

The formula for the GGM is shown below:

where:

• P₀ = stock's fair value (at year 0)
• DPS₀ = annual dividends per share (at year 0)
• g = perpetual dividend growth rate
• r_e = discount rate (required rate of return)

To effectively use the GGM, accurate derivation of its inputs is essential. The dividend at Year 0 (DPS₀) is the company's most recent dividend payment, obtainable from its financial statements or dividend history. The perpetual dividend growth rate (g) can be estimated from historical dividend growth, analyst estimates, or by estimating the sustainable (or "augmented sustainable") dividend growth rate. Lastly, the discount rate or required rate of return (r_e) reflects the investor's expected return, considering the investment risk. Typically, this is found by calculating the Capital Asset Pricing Model (CAPM), a model that explains the relationship between the expected return of a stock market investment and market risk.

The example further below in this article will provide an in-depth explanation of locating and calculating these inputs to the GGM.

Assumptions of the Gordon Growth Model (GGM)

The Gordon Growth Model (GGM) is predicated on several key assumptions. These assumptions, as described below, ensure the model's applicability and accuracy, particularly for companies with stable growth and predictable financial policies.

• Stable Business Model: The company's operations are expected to remain consistent, without significant shifts in strategy or diversification into new business areas. This stability implies a predictable market and competitive environment.
• Dividend Policy and FCFE: Free cash flow to equity (FCFE) represents the cash available to equity shareholders after all expenses, reinvestments, and debt repayments. The assumption in the GGM is that this FCFE is entirely distributed as dividends, particularly in firms that are fully equity-financed, thus linking dividends directly to the firm's free cash flow.
• Constant Growth Rate: The GGM assumes a stable and unchanging growth rate for both dividends and free cash flow to equity (FCFE), based on historical patterns and devoid of significant fluctuations.
• Stable Financial Leverage: The model anticipates no major changes in the company's capital structure, ensuring a consistent cost of equity capital and maintaining the company's risk profile.
• Perpetual Existence: This assumption extends beyond the ongoing operations of the company, suggesting that it will maintain its competitive position and profitability indefinitely, free from existential business threats.

These assumptions are foundational for the GGM, shaping its utility in stock valuations. They are especially critical for companies with stable, predictable financial policies and growth rates. However, when applying the GGM to high-growth companies, those undergoing significant changes, or firms with variable dividend policies, these assumptions may limit the model's effectiveness, as later discussed. Understanding and considering these assumptions is crucial for accurately applying the GGM in stock valuation.

Relevant Applications of the Gordon Growth Model (GGM)

In light of the Gordon Growth Model's (GGM) foundational assumptions, its most effective application is in contexts where these assumptions are not just met but are integral to the firm's operations. These optimal scenarios are characterized by stable growth rates, consistent dividend policies, and predictable financial structures, as described below:

• Firms with Stable Growth Rates: Ideal for firms growing at or below the economy's nominal rate, accompanied by established, continuous dividend policies and typically higher dividend payout ratios.
• Firms with High, Dividend-Payouts Reflecting FCFE: Best suited for companies where a significant proportion of free cash flow is regularly distributed as dividends.
• Firms with Stable Leverage: Companies with consistent leverage ratios align well with the model's expectations.

Given these optimal scenarios for the GGM, the ideal candidates and industries for the GGM include:

• Stable Blue-Chip Dividend-Paying Companies: Many blue-chip dividend-paying companies have a proven track record of consistent, long-term dividend growth and payouts, embodying the stability the GGM values.
• Real Estate Investment Trusts (REITs): By law, REITs must pay out 90% of their earnings as dividends, leading to a stable, predictable dividend cash flow. Their growth and investment policies are typically constrained, aligning with the GGM's steady growth assumption.
• Regulated Companies in Utilities and Energy: These companies operate within geographical and demographic constraints, aligning their growth with the economy's rate. They historically pay high dividends and maintain stable, often high, leverage.
• Large Financial Service Companies: The substantial size of these companies generally limits their growth potential. They tend to pay substantial dividends and have limited flexibility in adjusting leverage, making their financial metrics predictable.
• Companies With Established Dividend Policies: Firms that have consistently followed a dividend payout policy, especially those with a history of regular dividend increases, fit well within the GGM framework.

In conclusion, the GGM's efficacy is maximized when applied to companies and industries that inherently embody its core assumptions of stable growth, consistent dividend policies, and predictable financial leverage. These include blue-chip companies, REITs, regulated industries like utilities and energy, large financial firms, and companies with strong dividend payout histories. The GGM's primary assumption, that a company can sustain its dividend growth indefinitely, naturally excludes many players but remains invaluable for the right candidates. Its strength lies in its ability to accurately value firms that align with its criteria, making it a useful tool in the right contexts.

Limitations of the Gordon Growth Model (GGM)

Following our exploration of the Gordon Growth Model's (GGM) foundational assumptions and best use cases, it's important to acknowledge its limitations. These constraints are particularly relevant when considering the model's practical application in varying market scenarios:

• Constant Growth Assumption: The GGM's reliance on a steady dividend growth rate contrasts with the variable rates typical in most companies. The reality of fluctuating growth due to economic cycles and other factors often contradicts this assumption.
• Input Sensitivity: The outcomes of the model are highly sensitive to its growth rate (g) and discount rate (r_e). Variations in these inputs can lead to unrealistic valuations, with extremes resulting in negative values (i.e., when the growth rate exceeds the discount rate) or infinitely high stock valuations (i.e., when the growth rate is close to the discount rate).​
• Narrow Focus on Dividends: Concentrating exclusively on dividends, the GGM may miss broader market dynamics, which can lead to stock undervaluation. It doesn’t factor in non-dividend elements, potentially undervaluing stocks despite solid brand reputation and growth.
• Limited Applicability: Best suited for stable, dividend-paying companies, the GGM is less applicable for firms with inconsistent dividend patterns or those that don’t pay dividends at all. The model also might undervalue firms that retain earnings rather than distributing them as dividends.

In conclusion, while the GGM provides a simplified approach to stock valuation, its effectiveness is contingent on the stability of dividend growth and the accuracy of the required rate of return. It's a useful tool for investors to estimate the value of stocks with stable dividends, but it should be used with caution and in conjunction with other valuation methods to account for its limitations.

Gordon Growth Model (GGM) Example

For our example of valuing a dividend-paying company using the Gordon Growth Model (GGM), we'll use Southern Company (SO) as our case study. Southern Company is a prominent energy firm, primarily focused on electric utilities, and serves millions of customers across the southeastern United States.

This is an appropriate company to use for the GGM due to several key reasons:

1. Stable Dividend History: Southern Company has a long-standing history of consistent dividend payments, which aligns with the GGM's emphasis on predictable dividends.
2. Mature Industry: Operating in the utility sector, Southern Company is part of a mature industry characterized by steady demand and predictable growth, fitting the GGM's requirement for stable growth rates.
3. Financial Stability: As a large, established utility company, Southern Company typically maintains stable financial leverage, another critical assumption of the GGM.

For the GGM, three inputs are needed: the current dividend (DPS₀), which reflects the company's most recent dividend payment; the perpetual dividend growth rate (g), indicating the expected rate at which dividends will grow over time; and the discount rate (aka required rate of return) (r_e), the minimum yield investors seek, tied to the stock's risk profile. We'll calculate or find these inputs for Southern Company in the next sections and then interpret the result.

Step #1: Current Dividend (DPS₀)

To find the current dividend for Southern Company, you can look at their most recent financial statements or press releases, available on their official website under the investor relations section. Additionally, financial news websites and stock market analysis platforms often provide updated dividend information for publicly traded companies like Southern Company. These sources will list the latest dividend payment, which is the DPS₀ value needed for the GGM calculation.

According to the company's historical dividend information page, the company's 2023 annual dividend is $2.78, which will be our "DPS₀" in the GGM calculation.

Step #2: Discount Rate (r_e)

The discount rate (aka required rate of return), is primarily obtained from the Capital Asset Pricing Model (CAPM). Essential for determining the present value of future cash flows in dividend discount models, CAPM outlines the direct relationship between investment risk and expected return, indicating that higher risks command higher returns. This framework is vital for assessing how market risks influence investment valuations and expected outcomes.

The CAPM formula is shown below:

r_e = r_f + β*(r_m - r_f)

where:

• r_e = cost of equity
• r_f = risk-free rate
• β = beta
• r_m = expected market return

Solving for the cost of equity (r_e) provides the discount rate necessary for application in your present value dividend discount formulas.

Locating the three inputs to the CAPM for Southern Company is fairly straightforward:

• Risk-Free Rate (r_f): The risk-free rate, typically represented by the interest rate on the 10-year U.S. Treasury Note, is used because it's considered one of the safest investments. The U.S. government backs it, making it virtually free from default risk. This rate provides a baseline for assessing riskier investments. As of writing, this rate is 4.42%.
• Beta (β): Beta measures a stock's volatility relative to the overall market, representing systematic risk, which is the risk inherent to the entire market or market segment. A beta greater than 1 indicates that the stock is more volatile than the market, while a beta less than 1 means it's less volatile. Beta can be found on financial websites like Yahoo Finance under "Beta 5Y Monthly" for a specific company. Southern Company's 5-year monthly beta is currently 0.55.
• Expected Market Return (r_m): For the expected market return, using 10% is a common practice, reflecting the historical average annual return of a broad market index like the S&P 500. This figure is a general benchmark for what investors might expect the market to yield, on average, over time.

Using these inputs, we can calculate the CAPM for Southern Company:

r_e [SO] = 4.42% + 0.55*(10% - 4.42%) --> 7.49%

With a CAPM result of 7.49% for Southern Company, this figure represents the expected return on investment, considering the risk factors and market expectations. It suggests that any investment in the company should aim for at least this rate of return to compensate for the perceived risks.

• Related: How to Calculate and Interpret the Capital Asset Pricing Model (CAPM)

It's important to note, however, that while CAPM is the most conventional method for estimating a company's discount rate in the GGM, it's not the only approach. Other methods, such as simply using your personal required rate of return for the company, may also be employed to cross-verify or gain a more nuanced understanding of a company's risk and return profile.

Step #3: Perpetual Dividend Growth Rate (g)

To estimate the perpetual dividend growth rate (g), which forecasts the continual increase of dividends indefinitely, you can utilize the two methods outlined in this section.

For a more comprehensive understanding, I recommend reading my article on estimating the perpetual dividend growth rate. It offers additional methods beyond those discussed here and delves deeper into these topics.

Method #1: Historical Dividend Growth Rates

To estimate a company's perpetual dividend growth rate, one method is to analyze its historical growth rates, particularly over an extended timeframe like 5+ years. This approach gives insight into long-term trends while also highlighting recent dividend growth patterns, which are crucial for assessing the firm's current financial state.

Using the compound annual growth rate (CAGR) rather than a simple average in this analysis also ensures a more accurate representation of the dividends' year-over-year compounding growth.

For illustration purposes, I've collected dividend data for Southern Company from 2001 to 2023, as shown below:

Clearly, Southern Company has shown a stable and increasing dividend trend. With its historical growth rates and CAGRs both around 3-3.5%, the exact method for calculating the growth rate is less critical here.

To calculate the 10-year CAGR, we'll use the 2013 dividend of $2.01 and the 2023 dividend of $2.78. The formula for CAGR is:

CAGR = [(Ending Value / Beginning Value)^{(1 / Number of Years)}] - 1

Plugging in these values, the calculation would be:

CAGR (SO) = [(2.78 / 2.01)^(1/10)] - 1 --> 3.30%

The result of 3.30% can be comfortably utilized as our perpetual dividend growth rate (g) in the GGM calculation.

Method #2: Sustainable Dividend Growth Rate

The sustainable dividend growth rate is an effective method for estimating the rate at which a company can increase its dividend sustainably without requiring extra external funding. This approach is advantageous for the GGM as it considers the company's profitability and the proportion of earnings distributed as dividends. Often, this method yields a more realistic growth estimate than relying solely on historical data or analyst forecasts, since it's based on the company's actual financial performance.

The sustainable dividend growth rate formula is shown below:

Sustainable Dividend Growth Rate = ROE * (1 - (DPS / EPS))

where:

• ROE = return on equity (net income / shareholders' equity)
• DPS = annual dividend per share
• EPS = earnings per share ((net income - preferred dividends) / weighted average outstanding shares)

In this formula, return on equity (ROE) measures a company's profitability in relation to shareholder equity, illustrating how efficiently it converts shareholder capital into profits. A higher ROE suggests better efficiency in generating profits. The dividend payout ratio (DPS/EPS) shows the portion of earnings paid out as dividends; a lower ratio indicates more earnings are retained for reinvestment and potential growth.

The sustainable dividend growth rate formula combines these indicators to estimate a company's feasible dividend growth without raising the payout ratio or seeking extra capital. It presupposes that retained earnings will be reinvested at the ROE level, aiding growth. Thus, the formula underscores the concept that the sustainability of dividend growth is influenced by the role of retained earnings in enhancing profitability and their reinvestment extent.

Using numbers from Southern Company's FY 2022 financial statements, we can calculate the firm's sustainable dividend growth as follows:

Sustainable Dividend Growth Rate [SO] = 10.2% * (1 - ($2.78 / $3.28)) --> 1.55%

The FY 2022 sustainable dividend growth rate calculation for Southern Company suggests that the company can sustain a dividend growth rate of 1.55% into perpetuity. This rate is more conservative than our historical growth rate estimate, reflecting a growth capacity grounded in the company's current financial metrics. It's a useful perspective for the GGM, as it aligns dividend growth with the company's actual ability to generate and distribute earnings, offering a realistic view of sustainable growth. ​​

Align Dividend Growth With Economy's Growth Rate

In the Gordon Growth Model (GGM), the dividend growth rate (g) must be lower than the discount rate (r) to avoid unrealistic valuations. It should also not exceed the economy's growth rate where the firm operates. To ensure this, you can:

1. Cap at Economy's Growth Rate: Limit the dividend growth rate to the economy's growth rate, potentially allowing a slight exceedance of 1-2% if the model permits. This capping ensures that the company's dividend growth projections are sustainable and in line with broader economic conditions, preventing unrealistic and overly optimistic forecasts that could skew valuation results.
2. Risk-Free Rate as Benchmark: Use the 10-year U.S. Treasury Note interest rate as a conservative benchmark for the growth rate. This rate is considered a reliable proxy for the risk-free rate due to the U.S. government's strong creditworthiness. Employing it as a benchmark grounds the model in a realistic and stable financial environment, ensuring that the discount rate used in valuation reflects a minimal risk scenario.
3. Combine Inflation and Economic Growth: Merge long-term inflation with the average economic growth rate for a broader perspective. This combination accounts for the impact of inflation on a company’s future earnings and dividend potential, providing a more comprehensive view of the growth rate. This approach helps in adjusting the dividend growth rate in a way that reflects real economic conditions, offering a more realistic valuation.

Overall, these approaches help maintain a realistic growth rate, as no firm can indefinitely outgrow the economy or risk-free rate.

The 3.30% rate emerges as the most feasible for Southern Company's future dividend growth. It remains under the current risk-free and inflation rates, and well below the 7.49% cost of equity calculation, making it a suitable choice for the company's stable growth rate.

Step #4: Calculate and Interpret the GGM

Now that we have all the inputs, we can calculate the Gordon Growth Model (GGM) for Southern Company (SO), as follows:

The GGM intrinsic price of Southern Company, at $70.76 compared to its current stock price of ~$69.61, suggests the stock might be slightly undervalued. This could indicate a potential investment opportunity, though it's important to weigh this against other valuation methods and market factors, as the GGM's specific assumptions may not fully capture the company's market dynamics.

Furthermore, applying a margin of safety, such as 15%, which is modest but reasonable given the predictability of the company's dividends and its mature nature, helps protect against downside risk and the model's estimations. With this margin, the buy price adjusts to $60.10 ($70.76 * (1 - 0.15)). In this scenario, the company appears overvalued, as its buy price is below Southern Company's current stock price.

Lastly, conducting a sensitivity analysis is crucial for accurate valuations, given the model's sensitivity to input variables. An iterative data table is useful for this purpose, as it allows for the comparison of minor changes in the discount rate and perpetual growth rate and their effects on the intrinsic per-share value.

For example, the iterative data table below demonstrates how small, incremental changes of just 0.5% to the CAPM discount rate (7.49%) and the perpetual dividend growth rate (3.30%) significantly influence Southern Company's intrinsic value:

Furthermore, by concentrating exclusively on the sensitivity of the perpetual (aka stable) dividend growth rate, while keeping all other variables constant, we can observe that even small increments of 0.5% can significantly impact the model's intrinsic value:

Bottom line, these sensitivity analyses underscore the importance of carefully choosing the right candidate company, meticulously estimating the discount rate, and selecting the most suitable perpetual dividend growth rate. This approach is crucial in accurately applying the GGM for dividend discount valuations.

The Bottom Line

Valuing companies using the Gordon Growth Model (GGM) for dividend discount valuations offers a straightforward and effective approach to estimating the intrinsic value of stocks, especially for stable, mature companies with consistent dividend policies. The model's simplicity, focusing on future dividend payments and their growth, makes it a valuable tool for investors seeking to determine whether a stock is overvalued or undervalued.

However, its reliance on several critical assumptions, including constant dividend growth and stable business models, limits its applicability, particularly for high-growth or fluctuating companies. While the GGM provides a useful starting point in stock valuation, it should be employed judiciously and in conjunction with other valuation methods to capture the full financial picture of a company.