The Gordon Growth Model (also called the Dividend Discount Model, or DDM) is the standard way to value a share that pays a steadily growing dividend. It comes up in the CII R02 exam most years — usually as a simple plug-the-numbers question.
The formula
P₀ = D₁ ÷ (r − g)
Where:
| Symbol | Meaning |
|---|---|
| P₀ | Today's fair price of the share |
| D₁ | Next year's expected dividend (note: not this year's) |
| r | Required rate of return (often from CAPM) |
| g | Constant growth rate of the dividend, forever |
The model says a share is worth the next dividend divided by the gap between what investors demand (r) and how fast the dividend grows (g).
Worked example
Acme plc just paid a dividend of 20p. Dividends are expected to grow at 4% per year forever. Investors require a return of 9%.
Step 1 — Find next year's dividend (D₁):
D₁ = 20p × (1 + 0.04) = 20.8p
Step 2 — Apply the formula:
P₀ = 20.8p ÷ (0.09 − 0.04) = 20.8p ÷ 0.05 = 416p (£4.16)
So under the model, Acme's fair share price today is £4.16.
What R02 actually tests
Three flavours of question come up:
- Value a share — given D₀ (or D₁), r, and g, calculate P₀.
- Solve for r — rearrange to r = (D₁ ÷ P₀) + g. This is the implied "cost of equity".
- Compare to market price — if your model price > actual price, the share is undervalued; if model price < actual, it's overvalued.
Don't fall into these traps
- Using D₀ instead of D₁. The numerator is next year's dividend. If the question gives you D₀ ("the dividend just paid"), multiply by (1 + g) first.
- r ≤ g produces nonsense. If growth equals or exceeds the required return, the formula breaks (price would be infinite). The model only works when r > g.
- Treating g as variable. Gordon assumes a constant growth rate forever — this is a strong assumption and a common multi-stage DDM is used in real practice. R02 sticks to the simple version.
- Mixing percentages and decimals. Keep r and g consistent: either both decimals (0.09 and 0.04) or both percentages (9 and 4).
How to remember it
The denominator (r − g) is the net cost of holding the share — you demand r in return, but the growing dividend gives you back g for free. The smaller that gap, the higher today's price.
A 1% change in g (from 4% to 5%) in our example pushes the price from £4.16 to £5.20 — a 25% jump. That sensitivity is exactly why the model is famous (and why it's risky to use it for fast-growing shares).
Where it fits in R02
The Gordon Growth Model lives in the equity valuation sub-topic, alongside P/E ratios, dividend yield, and book value. It's also the cleanest illustration of the link between dividend growth and share price — a concept R06 case studies often lean on too.
Memorise D₁ ÷ (r − g), practise five worked examples, and you'll never lose the mark.