What a share is really worth
A share is a claim on a company's future distributions. The dividend discount model (DDM) takes that idea literally: the value of a share is the present value of all the dividends it will ever pay.
The most common version is the Gordon growth model, which assumes dividends grow at a constant rate forever. That is a strong assumption, and it is why the model suits mature, stable, dividend-paying businesses rather than young growth companies.
The model matters even when it is not used directly, because it makes the drivers of value explicit: the cash returned to shareholders, the growth of that cash, and the return investors demand for the risk.
Key points
- Value is the present value of the future dividend stream.
- The Gordon model assumes constant perpetual growth.
- It fits stable payers, not high-growth non-payers.
The Gordon growth model
V₀ = D₁ ÷ (r − g)
Value per share equals next year's dividend divided by the required return minus the growth rate.
- D₁
- Dividend expected next year
- r
- Required return for the risk
- g
- Perpetual dividend growth rate
D₁ = D₀ × (1 + g)
Grows the dividend just paid by one year.
r = (D₁ ÷ V₀) + g
Rearranges the model: the return is the dividend yield plus the growth rate.
The requirement r > g is not a technicality. If growth matched or exceeded the required return, the value would be infinite or negative, which tells you the constant-growth assumption has broken down.
Valuing a steady payer
A share has just paid a dividend of ৳32. Dividends are expected to grow at 6% a year, and investors require a 13% return for the risk.
Next year's dividend is ৳32 × 1.06 = ৳33.92. The value is ৳33.92 ÷ (0.13 − 0.06) = ৳33.92 ÷ 0.07 = ৳484.57. The dividend yield at that price is ৳33.92 ÷ ৳484.57 = 7.0%, and the remaining 6.0% of the required return comes from growth.
The model is extremely sensitive to the spread between r and g. If the required return were 12% instead of 13%, the value would rise to ৳565.33. A one-point change in a small spread moves the answer by 17%.
Key points
- D₁ = ৳33.92; value = ৳484.57.
- Required return splits into 7% dividend yield and 6% growth.
- Small changes in r or g cause large changes in value.
When to trust it, and when not to
The model works best for mature companies with stable payout policies and modest, durable growth: utilities, consumer staples, established banks, and infrastructure. For these, a constant growth assumption is a reasonable approximation.
It fails for companies that pay no dividend, that grow much faster than the economy for a period, or that have volatile payouts. Those need a multi-stage model that forecasts dividends year by year and applies steady growth only at the end, or a free-cash-flow model instead.
Use the model as a set of lenses rather than an oracle. Solve for the growth rate the current price implies, then ask whether that growth is plausible. That question is often more useful than the valuation itself.
Key points
- Best for stable, mature dividend payers.
- Use multi-stage or free-cash-flow models for growth companies.
- Invert the model to see what growth the market is pricing in.
Interactive experiment
Dividend discount model
The Gordon growth model values a share as the present value of a dividend stream growing at a constant rate forever.
V₀ = D₁ ÷ (r − g)
Your inputs
Dividend just paid per share.
Expected perpetual growth.
Return investors demand for the risk.
Result
- Value per share
- ৳485
- Next dividend (D₁)
- ৳34
- Dividend yield
- 7.0%
- Required return
- 13.0%
- Growth rate
- 6.0%
- Return − growth spreadA small spread produces a large value.
- 7.0%
- Capital gains component
- ৳224
At a spread of 7.0pp between required return and growth, the model values the share at 484.57.
03 / Apply
A utility versus a growth champion
A regulated utility has just paid a dividend of ৳48 and is expected to grow dividends by 3% a year. Investors require 9%. A technology company in the same portfolio pays a token dividend but is growing revenue at 25% a year.
The assumptions
- The utility's growth and payout are stable and predictable.
- The technology company's dividend will stay small for several years.
- The required return of 9% reflects the utility's lower risk.
What to take away
01
The utility can be valued with the Gordon model: ৳49.44 ÷ 0.06 = ৳824.00.
02
The technology company cannot: constant growth does not describe it.
03
Using one model for both would badly misprice one of them.
Your turn
0 of 4 answered
01Question
A share just paid a dividend of ৳32 and dividends grow at 6% a year. What is next year's dividend, D₁?
02Question
With D₁ of ৳33.92, a required return of 13%, and growth of 6%, what is the value per share? Round to two decimals.
03Question
If the shares trade at ৳500 while D₁ is ৳33.92 and growth is 6%, what required return does the price imply? Answer as a percentage, rounded to two decimals.
04Question
Which company does the Gordon growth model fit best?
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OpenStax · Principles of Finance, Stock Valuation chapter ↗Educational sample content. Worked examples use hypothetical figures. Dates refer to the note's latest content update.