GORDON’S THEORY ON DIVIDEND POLICY/ DIVIDEND DISCOUNT MODEL

It is a dividend relevance theory. This theory is in response to the theory of Modigliani and
Miller, who came up with the dividend irrelevance theory. It is also called the ‘Bird-in-the-
hand’ theory, which states that the current dividends are important in determining the firm’s
value. As per this theory, investors are more likely to prefer stock dividends than capital gains
from their stock investment. This theory rests on the premise that investors would choose certain
returns (dividends) over uncertain flows (capital appreciation) Gordon’s model is one of the most
popular mathematical models to calculate the company’s market value using its dividend policy.

The bird in hand theory implies that a company’s regular dividend-paying policy does impact the
company’s share price and investors’ behavior. The theory reasons that a low dividend payout
increases the cost of capital of a firm. This is because the investor expects that more retained
earnings will lead to higher growth and higher dividends in the future. And a higher dividend
payout boosts the share price.

Bird in Hand Argument

Gordon’s Model assumes that the investors are risk averse i.e. not willing to take risks and
prefers certain returns to uncertain returns. Therefore, they put a premium on a certain return and
a discount on the uncertain returns. The investors prefer current dividends to avoid risk; here the
risk is the possibility of not getting the returns from the investments.

But in case, the company retains the earnings; then the investors can expect a dividend in future.
But the future dividends are uncertain with respect to the amount as well as the time, i.e. How
much and when the dividends will be received. Thus, an investor would discount the future
dividends, i.e. Puts less importance on it as compared to the current dividends.

This theory is based on an old saying – ‘a bird in hand is worth two in the bush.’ current
dividends are the “bird in hand.” and the expectation of a big rise in the share price, which may
or may not happen, is the “two in the bush” – capital gains/ future dividends,
Relation of Dividend Decision and Value of a Firm

Gordon’s theory on dividend policy states that the company’s dividend payout policy and the
relationship between its rate of return (r) and the cost of capital (k) influence the market price per
share of the company.

Relationship between r and k Increase in Dividend Payout

r>k Price per share decreases
r<k Price per share increases
r=k No change in the price per share

Assumptions of Gordon’s Model

Gordon’s model is based on the following assumptions:

No debt: The model assumes that the company is an all-equity company, with no proportion of
debt in the capital structure. No external
financing: The model assumes that retained earnings finance all investments of the company,
and no external financing is required. Constant IRR: The
model assumes a constant Internal Rate of Return (r), ignoring the diminishing marginal
efficiency of the investment.
Constant Cost of Capital: The model is based on the assumption of a constant cost of capital
(k), implying the business risk of all the investments to be the same.

Perpetual earnings: Gordon’s model believes in the theory of perpetual earnings for the
company.

Corporate taxes: This model does not account for corporate taxes.

Constant retention ratio: The model assumes a constant retention/plowback ratio (b) once it is
decided by the company. Since the growth rate (g) = b*r, the growth rate is also constant by this
logic.

K>g: Gordon’s model assumes that the cost of capital (k)is more than the growth rate (g). This is
important for obtaining the meaningful value of the company’s share.

Perpetual life: The firm has an infinity life.

Valuation Formula of Gordon’s Model and its Denotations

According to the Gordon’s Model, the market value of the share is equal to the present value of
future dividends. It is represented as:

P = {EPS * (1-b)} / (k-g)

Where,

P = market price per share

EPS = earnings per share

B= retention ratio of the firm

(1-b) = payout ratio of the firm

K = cost of capital of the firm

G = growth rate of the firm = b*r

Implications of Gordon’s Model

Gordon’s model believes that the dividend policy impacts the company in various scenarios as
follows:

Growth Firm: A growth firm’s internal rate of return (r) > cost of capital (k). It benefits the
shareholders more if the company reinvests the dividends rather than distributing them. So, the
optimum payout ratio for growth firms is zero.

Normal Firm: A normal firm’s internal rate of return (r) = cost of the capital (k). So, it does not
make any difference if the company reinvests the dividends or distributes them to its
shareholders. So, there is no optimum dividend payout ratio for normal firms.

Declining Firm: The internal rate of return (r) < cost of the capital (k) in the declining firms.
The shareholders will get more benefits if the company distributes the dividends rather than
reinvesting them. So, the optimum dividend payout ratio for declining firms is 100%.

Criticism of Gordon’s Model

The main criticism of Gordon’s theory on dividend policy is due to unrealistic assumptions made
in the model.

Gordon model assumes that there is no debt and equity finance used by the firm. It is not
applicable in the real life situations,

According to Gordon’s model, there is no tax paid by the firm. It is not practically applicable

The Gordon’s Model is only applicable to all equity firms. It is assumed that the rate of returns is
constant, but, however, it decreases with more and more investments.

It is assumed that the cost of capital (K) remains constant but, however, it is not realistic in the
real life situations, as it ignores the business risk, which has a direct impact on the firm’s value.
Conclusion

Gordon’s theory of dividend policy is one of the prominent theories in the company’s valuation.
Though it comes with its limitations, it is a widely accepted model to determine the market price
of the share using the forecasted dividends.

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