Imagine you're a shareholder in Rajesh & Co. Pvt. Ltd. The company just earned ₹20 per share. Should it pay you a dividend now, or keep the money and reinvest it? Gordon's Model (by Myron Gordon) says: it depends on how well the company can reinvest that money. This is the heart of dividend relevance theory — and it's one of the most frequently tested models in Paper 6 FM.
The model gives us a formula to find the market price per share: P = E(1 – b) / (Ke – br), where E = Earnings Per Share, b = retention ratio (fraction of earnings kept back), (1 – b) = dividend payout ratio, Ke = cost of equity (shareholders' required return), r = internal rate of return on the firm's investments, and br = growth rate (g). The model assumes an all-equity firm, no external financing, constant r and Ke, no taxes, and perpetual earnings. These assumptions are important — examiners often ask you to list them.
Here's the golden rule Gordon gives us — memorise this table:
| Situation | Condition | What firm should do | Share Price |
|---|---|---|---|
| Growth firm | r > Ke | Retain more (lower dividend) | Higher with more retention |
| Declining firm | r < Ke | Pay more dividends | Higher with more payout |
| Normal firm | r = Ke | Dividend policy irrelevant | Unchanged |
Why? When r > Ke, the firm earns more on reinvested profits than shareholders could earn elsewhere — so retaining profits creates more value. When r < Ke, shareholders are better off receiving dividends and investing themselves. Gordon's key argument (the 'bird-in-hand' logic) is that investors prefer a certain rupee today over an uncertain rupee tomorrow — making current dividends more valuable. This makes Gordon's Model a dividend relevance theory, directly contrasting MM's irrelevance hypothesis. This distinction — relevance vs. irrelevance — is a 4-mark favourite in exams.