Page 22 - FINAL CFA II SLIDES JUNE 2019 DAY 7

WARM-UP: THE GENERAL READING 29: DISCOUNTED DIVIDEND VALUATION
DIVIDEND DISCOUNT MODEL

MODULE 29.2: GORDON GROWTH MODEL
4 Types of growth models:
• Gordon constant growth model.
• 2-stage growth model.
• H-model.
• 3-stage growth model.

With the appropriate model, we can forecast dividends up to the end of the investment horizon where we no longer have confidence in the
forecasts and then forecast a terminal value based on some other method, such as a multiple of book value or earnings. Choosing the
appropriate growth model is essential to accurate forecasts.

LOS 29.c: Calculate the value of a common stock using the Gordon growth model and explain the model’s underlying assumptions.

The Gordon growth model (GGM) assumes that dividends increase at a constant rate indefinitely.

which condenses to:

where:
V 0 = fundamental value
The model assumes that: D 0 = dividend just paid
D 1 = dividends expected to be received at end of Y1
• The firm expects to pay a dividend, D , in one year. r = required return on equity
1
• Dividends grow indefinitely at a constant rate, g (which may be less than zero). g = dividend growth rate
• The growth rate, g, is less than the required return, r.

A firm’s growth rate projections can be compared to the growth rate of the economy to determine if it can continue indefinitely. It is unrealistic to assume
that any firm can continue to grow indefinitely at a rate higher than the long-term growth rate in real gross domestic product (GDP) plus the long-term
inflation rate. In general, a perpetual dividend growth rate forecast above 5% is suspect.