Gordon growth model

The relationship that values a growing perpetual income stream as next year's income divided by the required return less the growth rate. The same formula produces a terminal value and a capitalisation rate.

Example

Requiring 9% in total while expecting 3% income growth means needing a 6% yield today, so 48,000 of income supports a value of 800,000.

Important

Required return equals yield plus growth, so every yield-based valuation contains a growth assumption whether or not anyone wrote it down. Where such a valuation looks generous, the generosity is usually sitting there.

Related terms

• Terminal value — The value assigned to everything beyond the explicit forecast period, most often by assuming the final forecast year's cash grows at a constant rate forever.
• Capitalisation rate — The required annual return used to convert an income stream into a price, most commonly in property. Value is net operating income divided by the rate.
• Dividend yield — The cash dividend paid over a year divided by the current share price - the income return actually received by a holder.

Lessons that explain it

• Yield-based valuation: pricing the income — Start from the money the asset actually pays out and the return you require, and the price falls out of the division. The simplicity is real, and it conceals the same growth assumption everything else makes. (11 min)
• Work backwards: what would have to be true to justify this price? — Rather than producing your own valuation and comparing it with the price, take the price as given and solve for the growth or margins it assumes. Then judge whether those assumptions are plausible. (11 min)

All 578 terms in the Investing glossary