NASAA Series 65, Uniform Investment Adviser Law ExaminationClient Investment Recommendations and StrategiesHard
A client is evaluating a growth stock that currently trades at $50 per share. The company is expected to earn $4 per share next year, and its earnings are projected to grow at a constant rate of 10% indefinitely. The required rate of return for this stock is 15%. What is the intrinsic value of this stock according to the Dividend Growth Model (Gordon Growth Model), assuming all earnings are paid out as dividends?
- A$133.33
- B$40.00
- C$100.00
- D$80.00
Show answer & explanationAnswer & explanation
Correct answer: D. $80.00
The Dividend Growth Model (Gordon Growth Model) calculates intrinsic value as D1 / (r - g), where D1 is the expected dividend next year, r is the required rate of return, and g is the constant growth rate of dividends. Given that all earnings are paid as dividends, D1 = $4. So, Intrinsic Value = $4 / (0.15 - 0.10) = $4 / 0.05 = $80.00.
Why the other options are wrong
- A. Incorrect calculation, possibly inverting the (r-g) component.
- B. Incorrect calculation, possibly dividing by (r+g) or other error.
- C. Incorrect calculation, possibly using only 'r' in the denominator.
Gordon Growth Model
A dividend discount model that calculates the intrinsic value of a stock based on a series of future dividends that are expected to grow at a constant rate indefinitely.
- Formula: P0 = D1 / (r - g).
- D1 = Expected dividend next year.
- r = Required rate of return; g = Constant dividend growth rate.
Memory trick: Gordon: Dividend next year divided by (rate minus growth).