,Describe strengths and limitations of the Gordon growth model and justify its selection to value a company's common shares.
· Explain the growth phase, transitional phase

, calculate the present value of all future dividends by applying the discount rate

,The first step, therefore, is to determine the value of these 'projected' dividends for the 2014 through 2017 fiscal years.
D2014 = $4.60 * 1.156 = $5.32 D2015 = $5.32 * 1.128 = $6.00 D2016 = $6.00 * 1.100 = $6.60 D2017 = $6.60 * 1.072 = $7.08
Next

Calculate and interpret the value of a common stock using the dividend discount model (DDM) for single and multiple holding periods.
· Calculate the value of a common stock using the Gordon growth model and explain the model's underlying assumptions.
· Calculate the value of noncallable fixed-rate perpetual preferred stock.
CFA Institute
4
LEARNING OBJECTIVES (2 OF 2)
After completing this chapter

, profitable, dividend-paying firms
- Noncontrolling shareholder perspective
· Gordon growth model:
- Assumes constant g and r > g
- Applicable to mature, stable firms
- Estimated value very sensitive to r - g denominator
CFA Institute
49
SUMMARY (2 OF 3)
· Uses of Gordon growth model:
- Preferred stock valuation where g = 0
- PVGO - Value from future growth
- Justified leading and trailing P/Es
- Implied r and g
· Phases of growth:
1

,The PV of that is $5/10% = $50
PVGO = PO - r
PVGO = $80 - 5 0.10
=$30
CFA Institute
21
EXAMPLE: PRESENT VALUE OF GROWTH OPPORTUNITIES (3 OF 3)
P 0
1
PVGO
E
=
-+ r
E
P 0
1
30 +
E
0.10
5
16=10+6
=
See Question 35 of the problem set.
CFA Institute
22
USING THE GORDON GROWTH MODEL TO DERIVE A JUSTIFIED LEADING P/E
The justified P/E can be used to determine what the P/E should be, given the firm's characteristics.
A justified P/E can be used to back out the market's implied growth rate for the firm.
0 V 0 =
r - g
P 0 DE
=
Recognizing that 1 - b is the dividend payout ratio (D/E)
1
r - g
P 0 1 -b
=
E 1
r- g
D1 1
To determine the justified leading P/E

we take the Gordon growth model and divide both sides by the earnings next year (E)
b is the retention ratio: how much earnings is retained in the firm.
CFA Institute
23
USING THE GORDON GROWTH MODEL TO DERIVE A JUSTIFIED TRAILING P/E
D 0 (1 + g )
VO = 0
r - g
P 0
D 0 (1 + g ) E 0
E 0
r - g
P 0
(1-b)(1+g
=
E0
r- g
=
P/E using recent history
CFA Institute
24EXAMPLE: USING THE GORDON GROWTH MODEL TO DERIVE A JUSTIFIED P/E
Stock price
$50.00
Trailing earnings per share
$4.00
Current dividends per share
$1.60
Dividend growth rate
5.0%
Required return on stock
9.0%
CFA Institute
25
EXAMPLE: USING THE GORDON GROWTH MODEL TO DERIVE A JUSTIFIED LEADING P/E
P 0 1
1-b
=
r- g
P 0
$1.60/$4.00
=
0.09-0.05
=10.0 E 1
CFA Institute
26
EXAMPLE: USING THE GORDON GROWTH MODEL TO DERIVE A JUSTIFIED TRAILING P/E
r- g P 0 ($1.60/ $4.00)(1.05) E0 P 0 E 0 _(1-b)(1+g) 0.09-0.05
=10.50 =
Actual P/E = $50.00/$4.00 = 12.50
Because the market is valuing the firm's earnings more than that justified by the firm's fundamentals

 Estimate a required return based on any DDM, including the Gordon growth model and the H-model.
· Calculate and interpret the present value of growth opportunities (PVGO) and the component of the leading price-to-earnings ratio (P/E) related to PVGO.
· Calculate and interpret the justified leading and trailing P/Es using the Gordon growth model.

, the stock is overvalued.
Justified P/E is different from real P/E which is just Price/Earnings.
Comparing leading and trailing P/E can give you indication whether the stock is 'overvalued' or not.
CFA Institute
27
ISSUES USING THE GORDON GROWTH MODEL
Strengths
Simple and applicable to stable, mature firms
Can be applied to entire markets
g can be estimated using macro data
Can be applied to firms that repurchase stock
Limitations
Not applicable to non-dividend-paying firms
g must be constant
Stock value is very sensitive to r - g
Most firms have nonconstant growth in dividends
D1/(r-g) e.g

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