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

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

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• pcunniff
Participant
• CFA Level 1
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 isÂ closestÂ 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 itÂ willÂ grow at a constant rate (5%) forever.

• Zee Tan
Keymaster
• CFA Charterholder
11

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:

$P=\frac{{D}_{1}}{r–g}$

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

$=CF8×1.05+\left(\frac{CF8×1.{05}^{2}}{0.103–0.05}\right)\phantom{\rule{0ex}{0ex}}=1.953125×1.05+\left(\frac{1.953125×1.{05}^{2}}{0.053}\right)\phantom{\rule{0ex}{0ex}}=2.05+40.63\phantom{\rule{0ex}{0ex}}=42.68$

• pcunniff
Participant
• CFA Level 1
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).