What is Gordon's Model (Dividend)?

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Grade Level:

Class 12

AI/ML, Physics, Biotechnology, FinTech, EVs, Space Technology, Climate Science, Blockchain, Medicine, Engineering, Law, Economics

Definition

What is it?

Gordon's Model is a way to figure out the fair price of a company's share based on the dividends it is expected to pay. It assumes that dividends will grow at a constant rate forever. This model helps investors decide if a share is a good buy.

Simple Example

Quick Example

Imagine your favourite snack shop promises to give you back ₹5 every month if you invest in it, and this 'give back' (dividend) will grow by 1% every month. If you want a 10% return on your money, Gordon's Model helps calculate how much you should pay for a share in that snack shop today.

Worked Example

Step-by-Step

Let's calculate the value of a share using Gordon's Model.

STEP 1: Identify the expected dividend next year (D1). Let's say it's ₹10.
---STEP 2: Identify the required rate of return (k). This is what an investor expects. Let's say it's 12% or 0.12.
---STEP 3: Identify the constant growth rate of dividends (g). Let's say it's 5% or 0.05.
---STEP 4: Apply the Gordon's Model formula: Share Value = D1 / (k - g).
---STEP 5: Substitute the values: Share Value = ₹10 / (0.12 - 0.05).
---STEP 6: Calculate the difference in the denominator: Share Value = ₹10 / 0.07.
---STEP 7: Divide to find the share value: Share Value = ₹142.85 (approximately).
---ANSWER: The fair value of the share is approximately ₹142.85.

Why It Matters

Understanding Gordon's Model helps you think like a financial expert. In FinTech, AI/ML models often use similar principles to predict stock prices. If you want to work in investment banking or become a financial analyst, this concept is a building block for valuing companies and making smart investment decisions.

Common Mistakes

MISTAKE: Using the current year's dividend (D0) directly in the formula | CORRECTION: The formula requires the *next year's* expected dividend (D1). If D0 is given, calculate D1 = D0 * (1 + g).

MISTAKE: Not converting percentages to decimals | CORRECTION: Always convert rates like 12% to 0.12 and 5% to 0.05 before using them in the formula.

MISTAKE: Assuming the growth rate (g) can be greater than or equal to the required rate of return (k) | CORRECTION: For the model to work, the growth rate (g) must always be less than the required rate of return (k). If g >= k, the formula gives an impossible or infinite value.

Practice Questions

Try It Yourself

QUESTION: A company just paid a dividend of ₹5 (D0). Its dividends are expected to grow by 6% annually. If an investor requires a 15% return, what is the fair value of the share according to Gordon's Model? | ANSWER: ₹58.89

QUESTION: If a share is currently trading at ₹200 and the next year's expected dividend (D1) is ₹15, with a constant growth rate of 4%, what is the implied required rate of return (k) for this share using Gordon's Model? | ANSWER: 11.5%

QUESTION: A company's latest dividend (D0) was ₹8. It's projected to grow by 7% for the next 3 years, then settle at a constant growth of 4% indefinitely. If the required rate of return is 12%, calculate the share value. (Hint: This requires a multi-stage model, but for Gordon's Model, assume the 4% constant growth starts from Year 4 onwards, and calculate P3 using D4). | ANSWER: ₹90.33 (Using D4 = D0 * (1.07)^3 * (1.04) and then P3 = D4 / (k-g) and discounting back)

MCQ

Quick Quiz

Which condition is essential for Gordon's Model to be applicable?

Dividends must be paid annually without fail.

The dividend growth rate must be less than the required rate of return.

The company must be a multinational corporation.

The growth rate must be negative.

The Correct Answer Is:

Gordon's Model works only if the growth rate (g) is strictly less than the required rate of return (k). If g >= k, the denominator becomes zero or negative, leading to an undefined or nonsensical share value.

Real World Connection

In the Real World

Financial analysts working for big investment firms or even small mutual funds use models like Gordon's to value shares of companies listed on the NSE or BSE. When you see news about a 'fair value' for a stock, chances are, they've used dividend discount models, including variations of Gordon's Model, to arrive at that number. It helps them advise clients whether to buy or sell shares.

Key Vocabulary

Key Terms

DIVIDEND: A portion of a company's profit paid out to its shareholders | REQUIRED RATE OF RETURN (k): The minimum return an investor expects to earn from an investment | GROWTH RATE (g): The constant rate at which dividends are expected to increase | SHARE VALUE: The estimated fair price of one share of a company

What's Next

What to Learn Next

Great job understanding Gordon's Model! Next, you should explore the 'Walter's Model' and 'MM Hypothesis'. These models also discuss dividends but from different angles, helping you get a complete picture of how dividend policy affects company valuation.