Gordon Model

Myron Gordon proposed a model of stock valuation using the dividend capitalization approach. His model is based on the following assumptions:

  1. Retained earnings represent the only source of financing for the firm. Thus, like the Walter model the Gordon model ties investment decision to dividend decision
  2. The rate of return on the firm’s investment is constant.
  3. The growth rate of the firm is the product of its retention ratio and its rate of return. This assumption follows the first two assumptions.
  4. The cost of capital for the firm remains constant and it is greater than the growth rate.
  5. The firm has a perpetual life.
  6. Tax does not exist.

Valuation Formula Gordon’s valuation formula is:

Implications

  1. When the rate of return is greater than the discount rate (r > k), the price per share increases as the dividend payout ratio decreases
  2. When the rate of return is equal to the discount rate (r = k), the price per share remains unchanged in response to variations in the dividend payout ratio.
  3. When the rate of return is less than the discount rate (r< k), the price per share increases as the dividend payout ratio increases

Thus the basic Gordon model leads to dividend policy implications as that of the alter model:

  1. The optimal payout ratio for a growth firm (r > k) is nil.
  2. The payout ratio for a normal firm is irrelevant.
  3. The optimal payout ratio for a declining firm (r < k) is 100 percent.
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