While the GGM method of DDM is widely used, it has two well-known shortcomings. The model assumes a constant dividend growth rate in perpetuity. This assumption is generally safe for very mature companies that have an established history of regular dividend payments. However, DDM may not be the best model to value newer companies that have fluctuating dividend growth rates or no dividend at all. One can still use the DDM on such companies, but with more and more assumptions, the precision decreases.

The second issue with the DDM is that the output is very sensitive to the inputs. For example, in the Company X example above, if the dividend growth rate is lowered by 10 percent to 4.5 percent, the resulting stock price is $75.24, which is more than 20 percent decrease from the earlier calculated price of $94.50.

The model also fails when companies may have a lower rate of return (r) compared to the dividend growth rate (g). This may happen when a company continues to pay dividends even if it is incurring a loss or relatively lower earnings.

### Using DDM for Investments

All DDM variants, especially the GGM, allow valuing a share exclusive of the current market conditions. It also aids in making direct comparison among companies, even if they belong to different industrial sectors.

Investors who believe in the underlying principle that the present-day intrinsic value of a stock is a representation of their discounted value of the future dividend payments can use it for identifying overbought or oversold stocks. If the calculated value comes to be higher than the current market price of a share, it indicates a buying opportunity as the stock is trading below its fair value as per DDM.

However, one should note that DDM is another quantitative tool available in the big universe of stock valuation tools. Like any other valuation method used to determine the intrinsic value of a stock, one can use DDM in addition to the several other commonly followed stock valuation methods. Since it requires lots of assumption and predictions, it may not be the sole best way to base the investment decisions.

The Gordon Growth Model is used to determine the intrinsic value of a stock based on a future series of dividends that grow at a constant rate. It is a popular and straightforward variant of a dividend discount model (DDM).

Given a dividend per share that is payable in one year and the assumption the dividend grows at a constant rate in perpetuity, the model solves for the present value of the infinite series of future dividends. Because the model assumes a constant growth rate, it is generally only used for companies with stable growth rates in dividends per share.

### The Formula For the Gordon Growth Model Is

\begin{aligned} &P = \frac{ D_1 }{ r – g } \\ &\textbf{where:} \\ &P = \text{Current stock price} \\ &g = \text{Constant growth rate expected for} \\ &\text{dividends, in perpetuity} \\ &r = \text{Constant cost of equity capital for the} \\ &\text{company (or rate of return)} \\ &D_1 = \text{Value of next year’s dividends} \\ \end{aligned}*P*=*r*−*g**D*1**where:***P*=Current stock price*g*=Constant growth rate expected fordividends, in perpetuity*r*=Constant cost of equity capital for thecompany (or rate of return)*D*1=Value of next year’s dividends