When a company is mature and stable, its dividends often grow at a predictable pace. The Gordon Growth Model, a cornerstone of dividend discount models (DDM), captures this idea. It calculates a stock's intrinsic value by assuming its dividends will grow at a constant rate forever.

The entire model boils down to a simple, elegant formula.

A key detail is using $D_1$, the dividend next year, not the dividend that was just paid ($D_0$). You can easily calculate it if you have the current dividend and the growth rate: $D_1 = D_0 \times (1 + g)$

The biggest challenge in using the Gordon Growth Model is estimating $g$, the sustainable growth rate. A company can't just invent growth. It comes from the profits it reinvests back into the business. We can estimate this with a formula that links profitability to reinvestment.

This formula makes intuitive sense. A company with a high Return on Equity that also retains a large portion of its earnings has more capital to fuel future growth, which in turn allows for higher future dividends.

For the required rate of return, $k$, analysts often use the Capital Asset Pricing Model (CAPM), which calculates the expected return based on the investment's risk relative to the overall market.

The model's simplicity is both a strength and a weakness. The valuation it produces is extremely sensitive to its inputs, particularly the difference between $k$ and $g$. A tiny change in either assumption can lead to a drastically different valuation.

Let's see this in action. Assume a stock is expected to pay a $2 dividend next year ($D_1$) and its required rate of return ($k$) is 8%.

As you can see, a one-percentage-point change in the growth rate creates a significant swing in the stock's estimated value. This is why the model is best suited for stable, mature companies like utilities or large consumer staples, where growth rates are low and predictable.

One crucial limitation is that the model breaks if $g$ is greater than or equal to $k$. Mathematically, this would produce a negative or infinite stock price, which is nonsensical. Conceptually, a company cannot grow faster than its required rate of return forever.

We can also use the model in reverse. If we know the current stock price, the expected dividend, and the required rate of return, we can solve for the growth rate that the market is currently "pricing in" to the stock.

This can be a powerful reality check. If the market's implied growth rate for a stable, old-line industrial company is 10%, you might question whether that assumption is realistic.

Time to test your understanding of these valuation concepts.

The Gordon Growth Model provides a solid foundation for valuation. While its assumptions are strict, it offers a clear link between a company's dividend policy, profitability, and its stock price.