Gordon Growth Model

There are two basic ways to make money in the stock market. The first involves the old "buy low, sell high" plan. That form of money-making is called capital appreciation. You buy the stock, wait until it goes up in value, then sell it to some other sucker when you think it's gotten as valuable as it's going to get.

The second way to make money from stocks comes from dividends. Dividends are cash payments a company makes to its shareholders.

You own 1,000 shares of Pay Me Now Inc., which you purchased at $15. It declares a quarterly dividend of $1 a share. So every three months, it sends you a check for $1,000...one dollar for every share you own.

One theory of stock valuation says that the share price for a company should reflect all future dividends you'll receive from the company. It's a way of computing the appropriate present value of a stock by calculating the present value of its future dividend payments.

That theory is known as the dividend discount theory. Or the Gordon Growth Model.

The "Gordon" part comes from the fact that the math was codified by Myron Gordon in the 1960s. The "growth" part of the name relates to the fact that the equation involves the dividend growth rate over time.

The equation looks like this: P = D1/ (r - g)

P here equals the current stock price. D1 is the value of next year's dividends. "g" measures the constant growth rate projected for the firm's dividends, and "r" gives the company's constant equity capital cost.