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Gordon Equation

WANT TO KNOW the expected return for an investment? You might take your cues from the Gordon Equation, named after the late Myron Gordon, a finance professor at the University of Toronto. The equation suggests you can calculate an investment’s expected return by combining two numbers: the income generated by the investment and the expected growth rate in that income.

Let’s say you have a bond that yields 3%. You can’t expect that 3% yield to grow, so 3% would also be your expected return. What if you buy a stock that’s yielding 3%? If you figure corporate earnings will grow 3% a year and the company will increase its dividend at the same rate, you’re looking at a 6% expected return.

This 6% expected return assumes that the company’s share price keeps pace with the rise in the dividend payment. That’s a reasonable long-run expectation, though short-term results will likely be all over the map. But assuming share prices do indeed climb with dividends, the Gordon Equation is another way to bring together income and capital gains—and thereby calculate total return, the topic discussed in the previous section.

Next: Calculating Interest

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