The Gordon Growth Equation is named after Myron Gordon who introduced it in the 1950s. It is a simplified model but it has turned out to be reasonably accurate over longer periods of time. The Gordon Growth Equation calculates the intrinsic value of a stock, based on a future series of dividends that grow at a constant rate.
The Gordon Equation can be simplified in order to avoid some mathematical hurdles. Without going into the details, it is possible to rewrite the Gordon Equation as Price = Dividend / (Expected Return – Dividend Growth Rate). This can also be rewritten as Expected Return = (Dividend / Price) + Dividend Growth Rate. Which is the same as Return = Dividend Yield + Dividend Growth Rate.
Obviously, the dividend and the price of share are easy to find out. But the dividend growth rate is tougher. Also note that the Gordon Equation assumes that the dividend growth rate is constant. This is very seldom true in the real world. It is quite clear that the Gordon Equation does not work very well for growth stocks, they seldom pay any dividend at all. It works better for mature companies that have a long history of dividend payments. But it has turned out that the Gordon Equation also works well for indices, such as the S&P 500 index.
But even for indices, the markets are often very volatile. Despite that, over time, the Gordon Equation works fine for indicies. S&P has paid roughly 2.5% in dividend and the real growth of the dividend has been almost 1.5%. This gives a real return of about 4%. This is reasonably close to the real world. Note that we are talking about real returns, removing inflation makes the return less impressive.
But it is worth remembering that the dividend yield has changed a lot over the years. It was at it highest during the depression in the 1930s, reaching an amazing 14%. But few wanted or dared to buy shares during the depression. On the other hand, the yield reached an all time low towards the end of the 20th century during the Internet boom, staying just a little bit above one percent. At that time, everyone and their dog wanted to buy shares in companies with no customers, no revenue and no profits, regardless of the price.
Needless to say, the Gordon Equation has been very useful during booms and busts. During the depression, it was a very good time to buy shares. Exactly as predicted by the Gordon Equation, mainly thanks to the high dividend yield. On the other hand, it was not a good time to buy shares towards the end of the Internet hype. The Gordon Equation made this very clear as well.
Thus, don’t ignore the Gordon Equation when planning your investment strategies. Over the long run, it is amazingly accurate despite its simplicity. It can also help you make the right decisions when most others are either panicking or buying everything they can get hold of. On the other hand, if you want to invest in growth stocks, you’d better find another valuation method.