Strengths and Limitations of the Gordon Growth Model

Strengths

• It is simple and easy to implement.
• It is appropriate for valuing mature, dividend-paying companies.
• It is used to judge whether an equity market is fairly valued.
• It is used to model the last growth stage in a multistage model for a company with a high growth rate.

Limitations

• The model is susceptible to the growth rate and required return rate estimates.
• The model must be used in collaboration with other models to value companies experiencing high growth rates.
• The model does not apply to companies not paying dividends.

Question

Which of the following is least likely a strength of the Gordon growth model?

1. It is appropriate for dividend-paying companies.
2. It is easy to implement.
3. It is sensitive to the growth rate estimate.

Solution

The correct answer is C. 

The sensitivity of the Gordon growth model to the growth rate estimate is one of the model’s limitations.

B is incorrect. The simplicity and ease of implementing the Gordon growth model are some of its strengths.

A is incorrect. One of the strengths of the Gordon growth model is it is appropriate for valuing dividend-paying companies.

Reading 23: Discounted Dividend Valuation

LOS 23 (h) Describe strengths and limitations of the Gordon growth model and justify its selection to value a company’s common shares.