Invented in the 1950s by Myron Gordon, the Gordon Growth Model is a financial equation used to determine the value of a stock. As a different take on the discounted cash flow model, the equation takes into account the dividend per share, rate of return, and dividend growth rate. This method of deduction is primarily used only with stable, blue-chip stocks. The Gordon equation is widely accepted by the financial community but may have several limitations.
The Gordon Growth Model is a variation of the cash flow model. The cash flow model is also a financial equation, but it covers a wider range of products. By examining incoming and outgoing finances, the cash flow model can provide the present values of projects, companies, and assets. This basic tool is skewed slightly and applied to the stock market in the Gordon model.
There are three pieces of information necessary to properly determine the value of a stock: the dividend per share (D), rate of return (K), and dividend growth rate (G). In order to properly execute the Gordon Growth Model, G must first be subtracted from K. This result must then be divided by D. The resulting number will be the approximate value of any stock. This equation's accuracy depends on the assumption that the stock will continue steadily increasing in value over the next year in order to determine the dividend per share. It is therefore usually only applied to blue-chip stocks because of their dependability.
The assumed increased value of the stock is not the only questionable aspect of the Gordon Growth Model. Financial experts must also be concerned if the value of K and G are too close, because the results will not be accurate. Also, the equation does not work with growth stocks because they do not pay a dividend. When these problems arise, different financial techniques must be utilized to determine the value of the stock in question.
Myron J. Gordon, a professor of Finance at the University of Toronto, published the Gordon Growth Model in 1959. Though he taught mostly in Canada, Gordon was an American citizen and served as president of the American Finance Association from 1975 to 1976. In honor of his lasting contributions to the study of finance, Gordon received several honorary degrees during his lifetime and was named a fellow to the Royal Society of Canada.