Gordon’s model also establishes the relationship in market price of the share and dividend payout ratio. The assumption under model are :
(i) Retained earnings in the only source of finance.
(ii) The internal rate of return and cost of capital is constant. The cost of capital for the firm is greater than the growth rate.
(iii) The corporate taxes does not exist.
(iv) The firm has a perpetual life.
(v) The growth rate of the firm is the product of internal rate of return and retention rate i.e., g = b ×r (where g is the growth rate, b is the retention rate and r is internal rate of return).
(vi) The retention rate once decided remains constant, then the company’s grows at a constant rate ‘g’.
Gordon’s valuation model is
P0 = E (1-b)/Ke-br
Where P0 is the market price of a share
E is the earning per share
b is the retention rate
Ke is the equity capitalization rate
r is the rate of return