CFA Level II ExamEquity InvestmentsEasy
An equity analyst is evaluating a mature, publicly traded company, 'SteadyHand Co.', known for its stable earnings and consistent dividend payouts. The analyst forecasts next year's dividend to be $2.50 per share, and the company's dividends are expected to grow indefinitely at a constant rate of 3.0% per year. The required rate of return for SteadyHand Co. is estimated to be 10.0%. What is the intrinsic value per share of SteadyHand Co. using the Gordon Growth Model?
- A$35.71
- B$25.75
- C$37.14
- D$25.00
Show answer & explanationAnswer & explanation
Correct answer: A. $35.71
The Gordon Growth Model (GGM) values a stock based on a constant growth rate of dividends. The formula is D1 / (r - g), where D1 is the next year's dividend, r is the required rate of return, and g is the constant growth rate of dividends. Plugging in the given values yields the intrinsic value per share.
Why the other options are wrong
- B. This is an incorrect calculation, possibly by adding the growth rate to the next dividend instead of using it in the denominator.
- C. This is an incorrect calculation, possibly by using D0*(1+g) as D1 and then dividing by r.
- D. This value would be obtained if the growth rate was ignored, calculating D1/r.
Gordon Growth Model (GGM)
A dividend discount model that assumes dividends grow at a constant rate indefinitely. It is used to determine the intrinsic value of a stock.
- Assumes constant dividend growth (g < r).
- D1 = Expected dividend in the next period.
- r = Required rate of return.
Memory trick: Grow Dividends Constantly, Get Value Now!