Dividend growth model
Also known as: Gordon growth model, constant growth dividend discount model
The dividend growth model values a stock as the present value of its future dividends, assuming those dividends grow at a constant rate. Its formula is value = next year's dividend ÷ (required return − growth rate).
The dividend growth model is a stock valuation method that treats a share's worth as the present value of all the dividends it will pay, assuming those dividends grow at a steady rate forever. The formula is: value = D1 ÷ (r − g), where D1 is the dividend expected next year, r is the investor's required rate of return, and g is the constant annual dividend growth rate.
A quick example shows the mechanics. Suppose a stock is expected to pay a $2.00 dividend next year, dividends grow 4% annually, and an investor requires a 9% return. The model values the stock at $2.00 ÷ (0.09 − 0.04) = $40. If the market price is below $40, the model suggests the stock is undervalued for that investor; above $40, overvalued.
The model's assumptions define its limits. It only works for companies that pay dividends and pay them with stable, predictable growth — mature, established firms like utilities and blue chips. It cannot value a growth company that pays no dividend, and it breaks down entirely when the growth rate approaches or exceeds the required return, since the denominator shrinks toward zero.
The Series 65 and Series 66 exams test the dividend growth model conceptually rather than computationally. Expect questions asking which companies the model applies to — those paying steadily growing dividends — and how it fits among valuation approaches alongside price-to-earnings ratios and discounted cash flow analysis.
Key takeaways
- The dividend growth model values a stock as value = D1 ÷ (r − g): next year's dividend divided by required return minus growth rate.
- It assumes dividends grow at a constant rate indefinitely, so it fits mature, stable dividend payers — not growth companies.
- If the model's value exceeds the market price, the stock looks undervalued for that investor's required return.
- On the Series 65 and Series 66 exams, know that the model is applicable only to companies that pay stable, growing dividends.