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# Finance Dictionary - G Terms

# Gordon Model

Many firms have sales and earnings that increase over time; their dividends may rise, as well. If we assume that a firm’s dividends grow at an annual rate of g percent, next year’s dividend, D1, will be D0(1 þ g)2. Generalizing, Dt ¼ D0(1 þ g)t: Substituting this into the equation for the present value of all future dividends, we can show that the price at any future time t can be defined as: Pt ¼ Dtþ1 r g , where Pt ¼ firm’s stock price at time t; Dtþ1 ¼ Dt(1 þ g), next year’s expected dividend (equals the current dividend increased by g percent); g ¼ the expected (constant) dividend growth rate; r ¼ required rate of return. This result, known as the Gordon model, or the constant dividend growth model, provides a straightforward tool for common stock valuation. The main assumption of constant growth in dividends may not be realistic for a firm that is experiencing a period of high growth or negative growth (that is, declining revenues). Neither will constant dividend growth be a workable assumption for a firm whose dividends rise and fall over the business cycle. The constant dividend growth model also assumes a dividend-paying stock; the model cannot give a value for a stock that does not pay dividends. In addition, in the denominator of the equation, the required rate of return, r, must exceed the estimated growth rate, g. Finally, the constant dividend growth model assumes estimates for r, the required rate of return, and g, the dividend growth rate. The constant dividend growth model reveals that the following three factors affect stock prices, ceteris paribus: 1) the higher the dividend, the higher the stock price; 2) the higher the dividend growth rate, the higher the stock price; 3) the lower the required rate of return r, the higher the stock price.