Gordon Growth Model: A Practical Guide to Valuing Stable Stocks

Let's talk about a problem. You find a company, maybe a utility or a consumer staples giant, that's been paying dividends like clockwork for decades. The stock price seems okay, but is it a good deal? Is it cheap, or is it priced for perfection? This is where valuation models come in, and one of the most famous—and famously misused—is the Gordon Growth Model.

Also known as the Dividend Discount Model (DDM), it's a deceptively simple formula that tries to pin a fair value on a stock based on its future dividend payments. The core idea is elegant: a stock is worth the sum of all its future dividends, discounted back to today's dollars. Myron Gordon gets the credit for popularizing it in the 1960s.

But here's the thing most articles won't tell you: using this model correctly is less about plugging numbers into a formula and more about having the guts to make a call on a company's long-term destiny. It forces you to answer one brutal question: "Can this company really keep growing its dividend forever, and at what rate?" Get that wrong, and your valuation is fantasy.

What Exactly Is the Gordon Growth Model?

Think of it as a financial telescope. It doesn't help you see next quarter's earnings. It's designed to gaze far into the horizon, at a company's "steady state"—that point in the distant future where growth settles into a predictable, perpetual rhythm. Gordon Growth Model

The model makes a few big assumptions. It assumes the company pays a dividend. It assumes that dividend will grow at a constant rate, year after year, forever. And it assumes you, the investor, have a required rate of return in mind. The output is an intrinsic value per share. If the market price is below that, the theory goes, you've found a bargain.

It's perfect for a specific breed of company: the mature, profitable, dividend aristocrat. Trying to use it on a fast-growing tech firm that reinvests all its cash? That's like using a hammer to screw in a lightbulb. It's the wrong tool.

The Formula, Piece by Piece

P = D₁ / (r - g)

Five characters. That's it. But each one carries immense weight.

P: The intrinsic value of the stock today. This is what we're solving for.
D₁: The expected dividend per share next year. Not last year's dividend. You have to make a forecast based on the company's payout history and near-term prospects. A common shortcut is to take the current annual dividend and grow it by your estimated growth rate (g).
r: The required rate of return (or discount rate). This is personal. It's your hurdle rate. What return do you need to compensate you for the risk of owning this stock? It often blends the risk-free rate (like the 10-year Treasury yield) and a risk premium for the stock market or the specific company. If you expect 10% annual returns from your portfolio, r might be 0.10.
g: The constant perpetual growth rate of the dividend. This is the trickiest, most important variable. It must be less than r, otherwise the formula blows up to infinity (nonsense). It also must be less than the long-term growth rate of the overall economy, or you're implying the company will eventually become the entire economy.

That last point about g is where novices trip. Setting g at 5% forever is incredibly optimistic for most firms. A more sober, long-term range for a mature company is often between the rate of inflation (2-3%) and nominal GDP growth (4-5%). Dividend Discount Model

A Realistic Step-by-Step Walkthrough: Valuing "StableCorp"

Let's get our hands dirty. Imagine a fictional company, StableCorp (ticker: STBL).

The Scenario: StableCorp is a regulated water utility. It's boring, predictable, and has raised its dividend every year for 25 years. It currently pays an annual dividend of $2.00 per share. The stock trades at $40. Your research suggests it can grow earnings—and thus dividends—by about 3% per year for the foreseeable future. Given its stable business, you'd be happy with a 8% annual return from this investment.

Here’s how we apply the Gordon Model:

Step 1: Forecast D₁. Next year's dividend. We take the current $2.00 and grow it by our 3% estimate. So, D₁ = $2.00 * (1 + 0.03) = $2.06.

Step 2: Define r and g. Our required return (r) is 8%, or 0.08. Our perpetual growth rate (g) is 3%, or 0.03.

Step 3: Plug into the formula. P = $2.06 / (0.08 - 0.03) = $2.06 / 0.05 = $41.20.

The Judgment: Our model says StableCorp is intrinsically worth $41.20 per share. It's trading at $40. That suggests it's slightly undervalued, maybe by about 3%. This isn't a screaming buy signal—it's more like the model saying the price is roughly fair. The real value here isn't in finding a massive discrepancy, but in confirming the market's price aligns with a rational, long-term assumption set.

Now, let's see how sensitive this is. What if we're wrong about the growth rate? Stock Valuation

Perpetual Growth Rate (g)	Intrinsic Value (P)	Vs. $40 Market Price
2.5%	$36.00	Overvalued by 10%
3.0% (Our Base)	$41.20	Fairly Valued
3.5%	$47.56	Undervalued by 19%

A half-percentage point change in the growth assumption swings the value by over 10%. This sensitivity analysis is the most important part of the exercise. It shows you what you're really betting on.

The Three Mistakes Almost Everyone Makes

After seeing this model misapplied for years, I've noticed patterns. These aren't small errors; they completely invalidate the output. Gordon Growth Model

Mistake 1: Using a Historical Average for g

Just because a company grew dividends at 7% over the past decade doesn't mean it can do so forever. Industries mature, competition increases, markets saturate. That past high growth rate is often a fading tailwind, not a perpetual engine. You need to estimate a sustainable long-term rate, which is almost always lower.

Mistake 2: Ignoring the Required Return (r)

People often just use a random number like 10% for r. But r isn't static. When interest rates rise, as they have recently, r should rise too. A higher r crushes the calculated intrinsic value (P). Failing to adjust your discount rate for the current macroeconomic environment is a classic error. Resources like the U.S. Securities and Exchange Commission (SEC) website can provide current risk-free rate benchmarks.

Mistake 3: Forcing the Model onto the Wrong Companies

This is the biggest one. The Gordon Model is terrible for companies that don't pay dividends, have erratic payout histories, or are in hyper-growth phases. Applying it to a biotech startup or a FAANG stock (except maybe Apple now) is an academic exercise at best, dangerous at worst. It will give you a number, but that number is meaningless. Dividend Discount Model

When It Works (And When It Doesn't)

Let's be crystal clear about the sweet spot and the minefields.

Use the Gordon Growth Model for: Mature, low-volatility companies in non-cyclical industries with a clear history of dividend payments. Think utilities (electric, water), certain consumer staples (toothpaste, food), some pharmaceuticals, and telecoms. These are businesses with predictable cash flows and limited growth avenues, making the "constant growth" assumption less crazy.

Avoid the Gordon Growth Model for:

Growth Stocks: Tech, software, innovation-driven firms. Their value is in reinvestment, not dividends.
Cyclicals: Automakers, airlines, semiconductors. Their earnings (and potential dividends) swing wildly with the economy.
Financials: Banks and insurers. Their dividend policies are heavily tied to regulatory capital requirements, not a smooth growth trend.
Any company with debt problems. A high dividend today might not be sustainable.

Its best use is as a sanity check within a broader toolkit. Compare its result to a valuation based on price-to-earnings or discounted cash flow. If they're wildly different, you need to figure out why. Stock Valuation

Tough Questions from Practitioners

In today's higher interest rate environment, how should I adjust my required return (r) for utilities or other "bond-proxy" stocks?

You have to bump it up, maybe significantly. For years, investors accepted low returns from utilities because bonds yielded nothing. That's changed. If the 10-year Treasury yield is 4.5%, your r for a utility can't be 6% anymore—the risk premium is too thin. I'd start at the risk-free rate (Treasury yield) and add a 3-5% equity risk premium for the sector. So, an r of 7.5% to 9.5% is more realistic now. This adjustment alone can slash the Gordon Model value of many income stocks, explaining why some have struggled recently.

My target company has a great dividend history, but the payout ratio is now over 90%. How does the Gordon Model handle this red flag?

It doesn't, and that's the point. The model blindly assumes the current dividend and growth rate are sustainable. A 90%+ payout ratio is a flashing warning sign that the dividend is at risk—there's barely any earnings left to reinvest for that future growth (g). Before you even open the formula, you must assess dividend safety. A high payout ratio forces you to lower your g estimate dramatically, possibly to zero or even negative if a cut seems likely. Using the historic growth rate here is a recipe for overvaluation.

Can I use the model for a company that occasionally pays special dividends on top of its regular one?

You can, but you shouldn't include the specials in D₁. The model assumes perpetuity, and special dividends are, by definition, not perpetual. Your D₁ should be your best estimate of the regular, recurring dividend payment for next year. If special dividends are a consistent part of shareholder returns (like some tech companies do), you could try to model them separately, but it gets messy. Often, it's cleaner to use a different valuation method for such companies.

The Gordon Growth Model isn't a magic calculator. It's a framework for disciplined thinking about the very long term. It forces you to articulate your assumptions about a company's eternal future. The number it spits out is less important than the process of getting there—the debate you have with yourself about sustainable growth, fair return, and business durability.

Use it as a probe, not a prophecy. When its result aligns with other methods and the story feels right, you might just have found a steady compounder for the long haul. Just remember to check your g at the door.