Gordon Growth Model

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Gordon Growth Model

A simple model to estimate the value of a stock. The model assumes one knows the dividend per share in the stock one year hence and, more importantly, that the dividends will grow at a constant rate indefinitely. Because of the latter assumption, the model is useful primarily for blue chip companies and other mature companies where dividend growth is unlikely to change. It is calculated thusly:

Stock Value = Dividend per share in one year / (Required rate of return - dividend growth rate)
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However, a number of asset-pricing models deviate from the standard Gordon model.
For example, if the next period cash flow is expected to be $1, the discount rate is 10 percent and the growth rate of cash flows 5 percent, then the Gordon Model would indicate a price of $20 (P=$1/(0.
The Additive Markov Gordon model (see Equation 1 of Yao 1997) and the Geometric Markov Gordon model (see Equation 2 of Yao 1997) are more recent examples of equity valuation models.
Another extension of the Gordon Model, developed by Donaldson and Kamstra (1996), permits predictably changing and auto-correlated dividend growth and discount rates.
While it is straightforward to adjust the Gordon Model for a simple scenario like this, the Donaldson and Kamstra (1996) technique permits extremely complex scenario analysis that is otherwise infeasible, scenarios in which the cash-flow growth rate and/or the discount rate never settle down, and possibly influence each other as well.
Note that this equation is essentially the same as the original Gordon model, except that instead of using long-term interest rates and growth rates, we used the present value of one-period interest rates and one-period growth rates of future dividends.
Yet people need to understand the concept of the real interest rate if they are to make the dynamic Gordon model work.
The Gordon model price for, say, 1980 was calculated by estimating g as the average annual growth rate in dividends and r as the average annual return to holding the S&P 500 index for the 1871-1979 period and using dividends paid during 1979.
Figure 2 compares S&P 500 data with Gordon model estimates.
Applying the Gordon model to the S&P 500 index annual data produces evidence of excessive market volatility (the forecast dividend yield is much less variable than the realized market yield) and of periods of inflated market prices--bubbles--in particular, during the 1920s, the 1960s, and the last half of the 1980s and 1990s.
Two examples of these models found in Yao (1997) are the additive Markov Gordon model (equation 1 in Yao) and the geometric Markov Gordon model (equation 2 in Yao) (see equations A5 and A6 in the appendix).
Applying these two extensions of the Gordon model to the S&P 500 index annual data also produces evidence of excessive volatility and periods of inflated market prices--the 1920s, the 1960s, the 1980s, and the 1990s.