CFA CFA Level 1 Dividend Discount Model Example: Why not Gordon Growth Model?

# Dividend Discount Model Example: Why not Gordon Growth Model?

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• This topic has 2 replies, 3 voices, and was last updated Dec-2310:01 am by pcunniff.
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• pcunniff
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• CFA Level 1
2

Hi everyone – hope everyone is grinding hard like me. Does anyone know why you dont use the gordon growth model here? Does it need to say Expected Div Growth Rate forever? Or something along those lines?

Use the following information on Brown Partners, Inc. to compute the current stock price.

Dividend just paid = \$6.10
Expected dividend growth rate = 4%
Expected stock price in one year = \$60
Risk-free rate = 3%
Risk premium on the stock = 12%

A)\$57.48.

B)\$59.55.

C)\$57.70.

Given explanation: The current stock price is equal to (D1 + P1) / (1 + ke). D1 equals \$6.10(1.04) = \$6.34. The equity discount rate is 3% + 12% = 15%. Therefore the current stock price is (\$6.34 + \$60)/(1.15) = \$57.70

(Study Session 13, Module 41.2, LOS 41.g)
Related Material SchweserNotes – Book 4

• Zee Tan
Keymaster
• CFA Charterholder
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The Gordon Growth Model is used to determine stock price as the present value of all future dividend payments:

$P=\frac{{D}_{1}}{\left(r–g\right)}$

where:

• P = Current stock price
• g = Constant growth rate expected for dividends, in perpetuity
• r = Constant cost of equity capital for the company (or rate of return)
• D1 â€‹= Value of next yearâ€™s dividendsâ€‹

The question has already given you the stock price one year from now, so Gordon Growth Model is not necessary. Instead you calculate the current value of the stock price by discounting it to today.

First you calculate the dividend payment 1 year from today, D1:

• = D0 * growth rate
• = \$6.10 * 1.04
• = \$6.34

So one year from today, you will have a dividend payment of \$6.34 and a stock worth \$60:

• \$6.34 + \$60 = \$66.34

Discounting it to today:

• = \$66.34 / (risk-free rate + equity premium)
• = \$66.34 / (1.15)
• = \$57.70

The answer explanation assumes that the expected stock price that they quote (\$60) is AFTER another dividend payment, which is not explicitly said in the question.