Gordon Growth Model

The Gordon Growth Model states: Value = CF₁ / (r − g), where CF₁ is the expected cash flow in the next period, r is the discount rate, and g is the perpetual growth rate. The intuition is that as the growth rate approaches the discount rate, the present value of the infinite stream of cash flows grows exponentially — which is why g must be less than r for the formula to produce a meaningful result. In a DCF, the GGM is applied at the end of the explicit projection period to capture the value of all cash flows beyond that point, producing the terminal value. The terminal growth rate is typically set between 2-3%, in line with long-term nominal GDP growth, because no company can grow faster than the economy forever.

When building a DCF model, analysts project explicit free cash flows for 5-10 years and then apply the GGM to calculate terminal value: TV = FCF₍ₙ₊₁₎ / (WACC − g). This terminal value is then discounted back to the present along with the explicit-period cash flows. The terminal value typically represents 60-80% of total enterprise value, which makes the growth rate assumption extremely impactful. Bankers always cross-check the perpetuity growth terminal value against the exit multiple method (applying an EV/EBITDA multiple to terminal-year EBITDA) to ensure the two approaches produce similar results. A large discrepancy signals that one assumption set may be unreasonable.

Beyond terminal value, the GGM can be used standalone to value dividend-paying stocks: Price = D₁ / (Ke − g), where D₁ is next year's expected dividend, Ke is the cost of equity, and g is the long-term dividend growth rate. This is the classic Dividend Discount Model (DDM) in its simplest form. The DDM is most appropriate for mature, stable companies with predictable dividend policies — think utilities, REITs, and large consumer staples companies. For high-growth companies that reinvest all earnings, the DDM is not practical because there are no near-term dividends to discount.

The GGM is highly sensitive to small changes in the growth rate. For example, with a 9% discount rate, changing the growth rate from 2% to 3% increases terminal value by approximately 14%. This sensitivity means the model can be easily manipulated — an analyst bullish on a stock can justify a much higher valuation simply by nudging the growth rate up by 50 basis points. To mitigate this risk, always present a sensitivity analysis showing how the valuation changes across a range of growth rates and discount rates. The GGM also assumes constant growth forever, which is unrealistic for cyclical or rapidly evolving industries.