Archive for March, 2006

Basics of the Gordon Equation

March 29, 2006

When I first encountered the Gordon equation (GE), a simple rule used to estimate/describe financial returns, in popular books I was confused and doubtful about various aspects of it. Eventually I hammered away at it in bits of spare time. It seems a lot clearer now — what it assumes and its range of validity and limitations. Anyone interested in the basic derivations I’ve written up, which are essentially trivial and try to be clear and keep the assumptions explicit, can view/download them with these links:

gordoneq.pdf (131 Kb PDF file)

or (85 Kb PostScript file)

From the introduction:

Outline of topics: Section 2 looks at the GE in the setting it’s commonly introduced in: the so-called dividend discount model, where it’s an exact solution. In Section 3 a more general model, with finite time period and including capital growth, is considered and the return is expanded as a small-dividend perturbation series. Section 4 specializes this further with the introduction of two simple price models. The GE emerges in the leading order parts of the expansion along with corrections due to valuation or dividend yield changes. In Section 5 these corrections to the Gordon return are illustrated with numerical examples. Section 6 briefly collects conclusions.

Comments and corrections are welcome.