## Gordon's Model – Assumptions, Advantages & Limitations
Gordon's Model (also called the Dividend Growth Model or Bird-in-Hand Model) values a share as the present value of all future dividends. It asserts investors prefer current dividends over uncertain future capital gains.
### Core Formula
P₀ = E(1 – b) / (Ke – br)
| Symbol | Meaning |
|---|---|
| E | Earnings per share |
| b | Retention ratio |
| (1 – b) | Dividend payout ratio |
| g = br | Sustainable growth rate in dividends |
| Ke | Cost of equity (capitalisation rate) |
| P₀ | Current market price per share |
### Assumptions
| Assumption | Detail |
|---|---|
| Pure Equity Firm | Company financed entirely through equity — no debt |
| All Constants | r, Ke, b, and g (= br) all remain constant indefinitely |
| Ke > g | Cost of capital must exceed growth rate (otherwise price = negative/infinite — meaningless) |
| Internal Financing | All investments funded only through retained earnings |
### Decision Rule (Same Logic as Walter's)
| Condition | Optimal Policy |
|---|---|
| r > Ke | Retain earnings (lower dividend → higher share price) |
| r < Ke | Pay dividends (higher payout → higher share price) |
| r = Ke | Dividend policy is irrelevant |
### Advantages
1. Clear linkage – directly relates the current share price to the present value of future dividends.
2. Easy to understand and apply – intuitive formula accessible to practitioners.
### Limitations
1. Forecasting difficulty – estimating g and Ke with accuracy is practically difficult and uncertain.
2. Constant assumptions are unrealistic – r, Ke, and g rarely stay constant over long periods for real companies.
3. Intrinsic value estimates are fragile – small changes in Ke or g dramatically alter the calculated price.