How Is a Company's Share Price Determined With the Gordon Growth Model?

Generally speaking, the stock market is driven by supply and demand, much like any market. When a stock is sold, a buyer and seller exchange money for share ownership. The price for which the stock is purchased becomes the new market price. When a second share is sold, this price becomes the newest market price, etc.

The more demand for a stock, the higher it drives the price and vice versa. So while in theory, a stock's initial public offering (IPO) is at a price equal to the value of its expected future dividend payments, the stock's price fluctuates based on supply and demand. Many market forces contribute to supply and demand, and thus to a company's stock price.

Company Value and Company Share Price

Understanding the law of supply and demand is easy; understanding demand can be hard. The price movement of a stock indicates what investors feel a company is worth—but how do they determine what it's worth? One factor, certainly, is its current earnings: how much profit it makes.

But investors often look beyond the numbers. That is to say, the price of a stock doesn't only reflect a company's current value—it also reflects the prospects for a company, the growth that investors expect of it in the future.

Predicting a Company's Share Price

There are quantitative techniques and formulas used to predict the price of a company's shares. Called dividend discount models (DDMs), they are based on the concept that a stock's current price equals the sum total of all its future dividend payments when discounted back to their present value. By determining a company's share by the sum total of its expected future dividends, dividend discount models use the theory of the time value of money (TVM).

The Gordon Growth Model

Several different types of dividend discount models exist. One of the most popular, due to its straightforwardness, is the Gordon growth model. Developed in the 1960s by U.S. economist Myron Gordon, the equation for the Gordon growth model is represented by the following:

Present value of stock = (dividend per share) / (discount rate - growth rate)

Or, as an equation:

$\begin{aligned} &P = \dfrac{D_1}{r-g}\\ &\textbf{where:}\\ &P = \text{\small Current Stock Price}\\ &g = \text{\small Constant growth rate in perpetuity }\\ &\text{\small expected for the dividends}\\ &r = \text{\small Constant cost of equity capital for that }\\ &\text{\small company (or rate of return)}\\ &D_1 = \text{\small Value of the next year's dividends }\\ \end{aligned}$​P=r−gD1​​where:P=Current Stock Priceg=Constant growth rate in perpetuity expected for the dividendsr=Constant cost of equity capital for that company (or rate of return)D1​=Value of the next year’s dividends ​

Example of Share Price Valuation With the Gordon Growth Model

For example, say Widget Inc. stock is trading at $100 per share. This company requires a 5% minimum rate of return (r) and currently pays a $2 dividend per share (D₁), which is expected to increase by 3% annually (g). 

The intrinsic value (p) of the stock is calculated as:

$2 / (0.05 - 0.03) = $100.

According to the Gordon Growth Model, the shares are correctly valued at their intrinsic level. If they were trading at, say $125 per share, they'd be overvalued by 25%; if they were trading at $90, they'd be undervalued by $10 (and a buying opportunity to value investors who seek out such stocks).

Drawbacks of the Gordon Growth Model

While useful in theory, there are some drawbacks of dividend discount models like the Gordon Growth Model. First, the model assumes a constant rate of growth in dividends per share paid by a company. In reality, many companies vary their dividend rates based on the business cycle, the state of the economy, and in response to unexpected financial difficulties or successes.

Another problem is estimating the appropriate discount rate (minimum rate of return). If the required rate of return turns out to be lower than the dividend growth rate, the result would be negative (i.e., meaningless). Similarly, if the required rate of return is equal to the dividend growth rate, you would have to divide by zero (which is impossible).

Finally, as mentioned above, these models are only useful for valuing dividend-paying stocks. Many companies, especially growth companies or those in the technology sector, do not pay dividends.

The Bottom Line

The Gordon Growth Model equation above treats a stock's present value similarly to perpetuity, which refers to a constant stream of identical cash flows for an infinite amount of time with no end date. Of course, in real life, companies may not maintain the same growth rate year after year, and their stock dividends may not increase at a constant rate.,