XYZ Company has just paid a dividend of $1.15. The required rate of return on the stock is 13.4%, and investors expect the dividend to grow at a constant 8% in the future.
a) Calculate the current stock value using the Gordon Constant growth model.
b) Evaluate Gordon's growth model and explain its limitations and why in certain situations the growth model used in part (a) will create incorrect results?
Gordon Growth Model:
Gordon growth model is also known as the dividend growth model. This model is applicable to pricing stocks whose dividends are known to grow at a constant rate indefinitely.
Answer and Explanation:
a) According to the Gordon Growth model, the price of a stock is given by:
- price per share = last dividend *(1 + dividend growth rate) / (required return - dividend growth rate)
- price per share = 1.15 *(1 + 8%) / (13.4% - 8%)
- price per share = 23
b) The Gordon growth model is based on the assumption that the dividend per share will be growing at a constant rate indefinitely. This is a rather strong assumption. Clearly, the model will deliver an incorrect estimate of the price of a stock is the stock's future dividends do not grow at the same rate, or if the firm ceases to pay dividends in the future.
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from Finance 101: Principles of FinanceChapter 14 / Lesson 3