What Is the Dividend Growth Model? Formula & Examples

The Dividend Growth Model — also known as the Gordon Growth Model (GGM) — is a stock valuation method that calculates a stock's intrinsic value based on the present value of its future dividend payments, assuming those dividends grow at a constant rate forever. It is one of the most elegant and widely taught valuation models in finance, and despite its simplicity, it provides a useful framework for thinking about what a dividend stock is worth. The core formula is straightforward:

Where P is the fair value of the stock, D1 is the expected dividend per share one year from now, r is the required rate of return (or discount rate), and g is the constant annual dividend growth rate. The model assumes dividends grow at rate g forever, which is why it works best for stable, mature companies with long track records of consistent dividend growth.

A Step-by-Step Example with Coca-Cola

Let us walk through a real-world example using Coca-Cola (KO). Suppose Coca-Cola's current annual dividend is $1.94 per share, and we expect it to grow at 4% per year (roughly in line with its 5-year average). If our required rate of return is 9% (a common equity discount rate), we calculate:

• D1 = $1.94 x (1 + 0.04) = $2.018
• r = 0.09 (9%)
• g = 0.04 (4%)
• P = $2.018 / (0.09 - 0.04) = $2.018 / 0.05 = $40.36

This suggests Coca-Cola's intrinsic value is about $40 per share under these assumptions. If the current market price is $62, the model suggests the stock is overvalued — or that the market is pricing in a lower required return, higher growth rate, or both. This highlights a key feature of the model: the output is extremely sensitive to the inputs, especially the difference between r and g.

Sensitivity to Inputs

The denominator (r - g) is the critical variable. Small changes in either the required return or the growth rate produce enormous changes in the calculated value. Using the same Coca-Cola example:

• If r = 8% and g = 4%: P = $2.018 / 0.04 = $50.45
• If r = 7% and g = 4%: P = $2.018 / 0.03 = $67.27
• If r = 9% and g = 5%: P = $2.037 / 0.04 = $50.93
• If r = 9% and g = 3%: P = $1.998 / 0.06 = $33.30

A 1% change in the required return swings the fair value by 25-50%. This sensitivity is both the model's greatest weakness and its most important lesson: valuation is fundamentally about assumptions, and reasonable people can disagree significantly about what a stock is worth.

When the Model Works Well

The Dividend Growth Model is most reliable for companies that exhibit these characteristics:

• Long dividend history: Companies like Procter & Gamble and Johnson & Johnson with 50+ years of consecutive increases have demonstrated remarkably consistent growth rates.
• Mature, stable businesses: Companies in consumer staples, utilities, and healthcare tend to grow dividends at relatively predictable rates.
• Growth rate below required return: The math only works if g < r. If a company's dividends are growing at 12% per year, the model produces a negative denominator and breaks down.

Limitations and Alternatives

The model has well-known limitations. The assumption of constant perpetual growth is unrealistic — no company grows at exactly the same rate forever. The model cannot value non-dividend-paying stocks (like Berkshire Hathaway or most tech companies). And as shown above, the output is hypersensitive to input assumptions.

The two-stage dividend growth model addresses some limitations by allowing for a high-growth phase followed by a stable-growth phase. For example, you might model a company growing dividends at 10% for five years before settling into a permanent 4% growth rate. This multi-stage approach produces more realistic valuations for companies in transition.

Despite its limitations, the Gordon Growth Model remains valuable as a quick sanity check, a teaching tool for understanding what drives stock prices, and a starting point for more sophisticated analysis. For dividend investors, it reinforces the key insight that a stock's value is ultimately determined by the cash it returns to shareholders — and how quickly that cash grows.