Limited Time Offer: Save 10% on all 2022 Premium Study Packages with promo code: BLOG10

# Gordon (Constant) Growth Dividend Discount Model and Two-stage Dividend Discount Model

## Gordon (Constant) Growth Dividend Discount Model

As the name implies, the Gordon (constant) growth dividend discount model assumes dividends grow indefinitely at a constant rate.

$$V_0=\frac{D_1}{r-g}$$

Where:

D1 = expected dividends in year 1

Note that this is of the utmost importance in your calculation. If you are given the dividend today, you would multiply D0 by (1+r) to have the dividend in one year.

r = required rate of return

g = growth rate

Analysts may use the following equation to estimate a company’s sustainable growth rate:

g = b × ROE

b = earnings retention rate or (1 – dividend payout ratio)

ROE = return on equity

## Multistage Dividend Discount Model

The two-stage dividend discount model is a bit more complicated than the Gordon model as it involves using both a short-term and a long-term growth rate to estimate a company’s current value. The two-stage DDM assumes that the company will pay dividends that grow at a constant rate at some point, but dividends are currently growing at an elevated and unsustainable rate. The intrinsic value of a share of stock using this model can be estimated as follows:

$$V_0=\sum_{t=1}^n\frac{D_0(1+g_s)^t}{(1+r)^t}+\frac{D_{n+1}/(r-g_L)}{(1+r)^n}$$

Where:

Dn+1 = D0(1 + gS)n(1 + gL)

This means that the long-term dividend is the dividend today, multiplied by one plus the short-term dividend for a number of periods n, then multiplied by one plus the long-term growth rate

n = years of short-term growth

gS = short-term growth rate

gL = long-term growth rate

While several equations are involved, the two-stage DDM calculation boils down to the sum of the discounted short-term dividends and the discounted long-term dividends. The short-term dividends have to be rolled back to the present (t = 0), while the value of the long-term dividends must first be calculated at the time of transition from short-term to long-term (t = n).

The number of stages used in valuation should not be solely based on the company’s age, as many long-established companies can experience periods of above-average or below-average growth.

### Question

Using the Gordon (constant) growth dividend discount model and assuming that r > g > 1%, what would be the effect of a 1% decrease in both the required rate of return and the constant growth rate on the stock’s current valuation? Assume there is no change to current dividend payment (D0).

1. Current valuation would increase.
2. Current valuation would decrease.
3. Current valuation would remain unchanged.

Solution

If both the required rate of return and growth rate are decreased by the same amount, the denominator should remain unchanged. However, to calculate the current value, the current dividend must be rolled ahead one year by multiplying D0 by (1+g). While the current dividend payment is unchanged in this instance, Dwill decrease slightly when g is decreased by 1% thus making the current valuation lower than it was previously.

Shop CFA® Exam Prep

Offered by AnalystPrep

Featured Shop FRM® Exam Prep Learn with Us

Subscribe to our newsletter and keep up with the latest and greatest tips for success
Shop Actuarial Exams Prep Shop GMAT® Exam Prep

Sergio Torrico
2021-07-23
Excelente para el FRM 2 Escribo esta revisión en español para los hispanohablantes, soy de Bolivia, y utilicé AnalystPrep para dudas y consultas sobre mi preparación para el FRM nivel 2 (lo tomé una sola vez y aprobé muy bien), siempre tuve un soporte claro, directo y rápido, el material sale rápido cuando hay cambios en el temario de GARP, y los ejercicios y exámenes son muy útiles para practicar.
diana
2021-07-17
So helpful. I have been using the videos to prepare for the CFA Level II exam. The videos signpost the reading contents, explain the concepts and provide additional context for specific concepts. The fun light-hearted analogies are also a welcome break to some very dry content. I usually watch the videos before going into more in-depth reading and they are a good way to avoid being overwhelmed by the sheer volume of content when you look at the readings.
Kriti Dhawan
2021-07-16
A great curriculum provider. James sir explains the concept so well that rather than memorising it, you tend to intuitively understand and absorb them. Thank you ! Grateful I saw this at the right time for my CFA prep.
nikhil kumar
2021-06-28
Very well explained and gives a great insight about topics in a very short time. Glad to have found Professor Forjan's lectures.
Marwan
2021-06-22
Great support throughout the course by the team, did not feel neglected
Benjamin anonymous
2021-05-10
I loved using AnalystPrep for FRM. QBank is huge, videos are great. Would recommend to a friend
Daniel Glyn
2021-03-24
I have finished my FRM1 thanks to AnalystPrep. And now using AnalystPrep for my FRM2 preparation. Professor Forjan is brilliant. He gives such good explanations and analogies. And more than anything makes learning fun. A big thank you to Analystprep and Professor Forjan. 5 stars all the way!
michael walshe
2021-03-18
Professor James' videos are excellent for understanding the underlying theories behind financial engineering / financial analysis. The AnalystPrep videos were better than any of the others that I searched through on YouTube for providing a clear explanation of some concepts, such as Portfolio theory, CAPM, and Arbitrage Pricing theory. Watching these cleared up many of the unclarities I had in my head. Highly recommended.