Question

Robert Campbell and Carol Morris are senior vice-presidents of the Mutual of Chicago Insurance Company. They are co-directors of the company’s pension fund management division. A major new client has requested that Mutual of Chicago present an investment seminar to illustrate the stock valuation process. As a result, Campbell and Morris have asked you to analyze the Bon Temps Company, an employment agency that supplies word processor operators and computer programmers to businesses with temporarily heavy workloads. You are to answer the following questions.

What happens if the growth is constant, and g > rs? Will many stocks have g > rs?

Answer 1

If growth is constant, We know Gordon growth model says that Share price=Expected Dividend/(required return-growth rate)

If g>rs, it means that it is a very high growth company and has growth rate more than the cost of equity. Such companies having this high sustainable growth rate would be very few.

In this case, we cannot use Gordon growht model because using that model, share price will become negative which cannot happen. In that case, we will have to use other valuation models.