CFA CFA Level 1 2-Stage Dividend Discount Model example with Gordon Growth Model formula

Equity

2-Stage Dividend Discount Model example with Gordon Growth Model formula

  • Author
    Posts
    • Avatar of pcunniffpcunniff
      Participant
        • CFA Level 1
        Up
        13
        ::

        Anyone know how to do this for the Gordon growth model?

        A stock that currently does not pay a dividend is expected to pay its first dividend of $1.00 five years from today. Thereafter, the dividend is expected to grow at an annual rate of 25% for the next three years and then grow at a constant rate of 5% per year thereafter. The required rate of return is 10.3%. The value of the stock today is closest to:

        1. $20.65.
        2. $22.72.
        3. $23.87.

        Explanation: This is essentially a two-stage dividend discount model (DDM) problem. Discounting all future cash flows, we get:

        Note that the constant growth formula can be applied to dividend 8 (1.253) because it will grow at a constant rate (5%) forever.

        mikey voted uppcunniff voted up
      • Avatar of Zee TanZee Tan
        Keymaster
          • CFA Charterholder
          Up
          10
          Accepted answer
          ::

          I got A as my answer.

          • CF0 = 0
          • CF1 = 0
          • CF2 = 0
          • CF3 = 0
          • CF4 = 0
          • CF5 = 1
          • CF6 = 1*(1.25) = 1.25
          • CF7 = 1*(1.25)2 = 1.5625
          • CF8 = 1*(1.25)3 = 1.953125
          • CF9 = 42.68 (see explanation below)
          • I = 10.3%
          • NPV = $20.65

          CF9 = dividend + price by Gordon Growth Model

          Gordon Growth Model formula:

          P=D1rg

          where

          • P = price
          • D1= value of next year’s dividend
          • r= required rate of return
          • g=constant rate of growth

          So calculating CF9

          CF9 = dividend + price by Gordon Growth Model

          =CF8×1.05+CF8×1.0520.1030.05=1.953125×1.05+1.953125×1.0520.053=2.05+40.63=42.68

          mikey voted upKajalDighe voted up
        • Avatar of pcunniffpcunniff
          Participant
            • CFA Level 1
            Up
            4
            ::

            I just straight up struggle at these DDM questions. I am constantly wondering if I have to take the req rate of return as the denominator versus the constant growth at just D/expected rate of return – growth. You get growth at times by taking ROE * RR (1-div payout). So much to remember and I STILL get the questions wrong. Any last minute tips on this? Figure I should focus on stronger areas and not get bogged down here (though I know its very important).

            mikey voted up
        Viewing 2 reply threads
        • You must be logged in to reply to this topic.