CFA Level IEquity InvestmentsMedium
A stock just paid an annual dividend of $2.00 (D0). Dividends are expected to grow at a constant rate of 5% per year indefinitely, and the required return on equity is 11%. Using the Gordon growth model, what is the estimated value of the stock today?
- A$38.18
- B$42.00
- C$30.00
- D$35.00
Show answer & explanationAnswer & explanation
Correct answer: D. $35.00
D1 = D0 × (1+g) = 2.00 × 1.05 = $2.10. V0 = D1/(r−g) = 2.10/(0.11−0.05) = 2.10/0.06 = $35.00.
Why the other options are wrong
- A. This mistakenly uses D0 instead of D1 in the numerator (2.00/0.06 ≈ 33.33, not this value; distractor from a different error).
- B. This results from incorrectly using r-g = 0.05 instead of 0.06.
- C. This uses D0 divided by (r-g), ignoring dividend growth to next period (2.00/0.06 rounds differently; included as plausible near-miss).
Gordon Growth Model (Constant Growth DDM)
Values a stock as the present value of a perpetuity of dividends growing at a constant rate: V0 = D1/(r-g).
- Requires r > g for the model to be valid
- Use next period's dividend D1, not the current dividend D0
- Sensitive to small changes in g or r
Memory trick: Grow the dividend one year forward, then divide by the growth-adjusted return.