CFA Level II Exam · Discounted Dividend Valuation

Gordon Growth Model for CFA Level II

Updated 7 October 2026 · Fact-checked

The Gordon growth model values a stock as the present value of dividends that grow at a constant rate forever: V0 = D1 ÷ (r − g), with r greater than g. Find D1, confirm r and g are given, check r > g, then substitute. Rearrange for r or g when price is known.

Understand Gordon Growth Model

A stock's value is the present value of the cash it will pay you. The dividend discount model (DDM) says value equals the discounted value of all future dividends. Forecasting dividends forever is impossible, so you add an assumption.

The Gordon growth model (constant-growth DDM) assumes dividends grow at the same rate g every year, forever. Then the infinite series collapses into one fraction: V0 = D1 ÷ (r − g). Here D1 is the dividend expected one year from now, r is the required return on equity, and g is the constant growth rate.

The model only works if g is below r. If g ≥ r, the formula gives a negative or infinite value, which is meaningless. The model also fits mature, stable, dividend-paying firms best. It is very sensitive to the gap r − g: a small change in g or r moves the value a lot.

You can run the model backwards. If you know the market price, you can solve for the implied required return, r = D1 ÷ P0 + g, or the implied growth rate, g = (P0 × r − D0) ÷ (P0 + D0). The first is the dividend yield plus growth. The second comes from rearranging P0 = D0(1 + g) ÷ (r − g).

Dividing the model by earnings gives a justified P/E. Because D1 = payout ratio × E1, the leading justified P/E is P0 ÷ E1 = payout ÷ (r − g). The trailing justified P/E is P0 ÷ E0 = payout × (1 + g) ÷ (r − g). In a vignette, expect to move between these forms.

Key formulas to remember

Gordon growth value: V0 = D1 ÷ (r − g) = D0 × (1 + g) ÷ (r − g); Requires g < r and constant growth forever. D1 is next year's dividend.
Implied required return: r = D1 ÷ P0 + g; Use the market price as P0. Dividend yield on D1 plus growth.
Implied growth rate: g = (P0 × r − D0) ÷ (P0 + D0); Derived from P0 = D0(1 + g) ÷ (r − g). If D1 is given, use g = r − D1 ÷ P0.
Sustainable growth: g = b × ROE, where b = 1 − payout ratio; Retention rate times return on equity. Gives g when the vignette supplies payout and ROE.
Justified leading P/E: P0 ÷ E1 = (D1 ÷ E1) ÷ (r − g); Payout ratio on next year's earnings divided by r − g.
Justified trailing P/E: P0 ÷ E0 = (D0 ÷ E0) × (1 + g) ÷ (r − g); Equals leading P/E times (1 + g).

How to solve Gordon Growth Model questions

Use the same sequence on any Gordon growth question in an item set.

1Read the vignette and list what is given: D0 or D1, EPS, payout ratio, ROE, price, r, g. Note whether the dividend is current (D0) or next year's (D1).
2Check the model fits: stable growth, dividends paid, and r > g. If the vignette says growth is high or temporary, the model is not suitable.
3Get g if needed: use b × ROE, or the growth given. Get r if needed from CAPM: r = Rf + β × (equity risk premium).
4Convert to D1: D1 = D0 × (1 + g). Skip this if D1 is already given.
5Substitute into V0 = D1 ÷ (r − g), or rearrange for r or g if price is the known figure.
6For a P/E question, use payout ÷ (r − g) for the leading P/E, then multiply by (1 + g) for the trailing P/E.
7Compare value with market price if asked: value above price suggests undervalued, below suggests overvalued. Check that your answer is reasonable.

Quickest way: Three-line shortcut

When to use it: Use when the vignette gives clean numbers and you need one value, rate or multiple quickly.

Write D1 first. Multiply D0 by (1 + g) before anything else.
Compute r − g as a single number and check it is positive.
Divide. For implied r, use yield + g: D1 ÷ P0 + g. For implied g with D1 known, use r − D1 ÷ P0.
For P/E, skip the price: payout ÷ (r − g) gives the leading multiple directly.

Common mistakes in Gordon Growth Model

Using D0 in the numerator instead of D1
The vignette gives the dividend just paid and it is easy to plug in directly.
Fix: Always ask which year the dividend belongs to. Multiply D0 by (1 + g) unless D1 is stated.
Using the model when g ≥ r
Students substitute without checking, or use a high near-term growth rate.
Fix: Check r > g first. If it fails, the constant-growth model is not valid and a multistage model is needed.
Mixing leading and trailing P/E
Both forms look alike and the (1 + g) factor is easy to drop.
Fix: Leading uses E1 and payout ÷ (r − g). Trailing uses E0 and multiplies by (1 + g).
Entering growth or return as whole numbers
Rushing under time pressure, for example typing 5 instead of 0.05.
Fix: Convert percentages to decimals before the calculation, then re-check the size of the answer.
Computing sustainable growth with payout instead of retention
Confusion between payout ratio and retention rate b.
Fix: g = (1 − payout) × ROE. A firm with a 40% payout retains 60%.

Worked examples

Example 1

Vignette: Altamar Foods, a mature packaged-food company, paid an annual dividend of €2.00 per share this year. An analyst expects dividends to grow at 4% a year indefinitely. Using CAPM, the analyst sets the risk-free rate at 3.0%, beta at 0.9 and the equity risk premium at 5.0%. The shares trade at €35. Q1: What is the required return? Q2: What is the Gordon growth value? Q3: Is the stock under- or overvalued?

Show the solution

Q1: r = 3.0% + 0.9 × 5.0% = 3.0% + 4.5% = 7.5%.
Q2: D1 = 2.00 × 1.04 = 2.08.
r − g = 7.5% − 4.0% = 3.5% = 0.035.
V0 = 2.08 ÷ 0.035 = 59.43.
Q3: Value of €59.43 is above the price of €35, so the stock appears undervalued under these assumptions.

Answer: Q1: 7.5%. Q2: €59.43. Q3: Undervalued relative to the model, though the result is highly sensitive to the small r − g gap.

Example 2

Vignette: Norvik Utilities has EPS of $4.00 this year and a payout ratio of 60%. Its ROE is 10%. The required return on equity is 9%. Q1: What is the sustainable growth rate? Q2: What is the justified leading P/E? Q3: What is the justified trailing P/E?

Show the solution

Q1: Retention b = 1 − 0.60 = 0.40. g = 0.40 × 10% = 4.0%.
Q2: r − g = 9% − 4% = 5% = 0.05. Leading P/E = 0.60 ÷ 0.05 = 12.0.
Q3: Trailing P/E = leading P/E × (1 + g) = 12.0 × 1.04 = 12.48.

Answer: Q1: 4.0%. Q2: 12.0. Q3: 12.48.

Exam tips

Look at the dividend label first. Whether the vignette gives D0 or D1 decides the first step and is a common trap.
Expect the model to be paired with CAPM for r and with b × ROE for g. Practise chaining them in one pass.
When asked about suitability, link the model to stable, mature, dividend-paying firms and note sensitivity to r − g.
Implied-return questions often ask you to compare r from the market price with your own required return to reach a buy or sell view.
There is no penalty for wrong answers, so never leave an item blank, but check r > g before choosing a numeric option.

Gordon Growth Model in other exams

The same ground in other exams, if you are preparing for more than one or want another angle on it.

Gordon Growth Model: frequently asked questions

What is the Gordon growth model formula?

V0 = D1 ÷ (r − g), where D1 is next year's dividend, r is the required return and g is the constant growth rate. It requires g to be less than r. If you have D0 instead, use D0 × (1 + g) ÷ (r − g).

How do I calculate the implied growth rate from the Gordon growth model?

Rearrange P0 = D0(1 + g) ÷ (r − g) to get g = (P0 × r − D0) ÷ (P0 + D0). If D1 is given, it is simpler: g = r − D1 ÷ P0. Use the current market price as P0.

What are the limitations of the Gordon growth model?

It assumes dividends grow at one constant rate forever, so it suits mature dividend-paying firms and not high-growth or non-paying ones. It is very sensitive to the gap between r and g. It breaks down if g is equal to or greater than r.

How do I get the justified P/E from the Gordon growth model?

Divide the model by earnings. The leading justified P/E is payout ratio ÷ (r − g). The trailing justified P/E is payout × (1 + g) ÷ (r − g), which is the leading P/E times (1 + g).