Question

Stocks and Their Valuation: Discounted Dividend Model

The value of a share of common stock depends on the cash flows it is expected to provide, and those flows consist of the dividends the investor receives each year while holding the stock and the price the investor receives when the stock is sold. The final price includes the original price paid plus an expected capital gain. The actions of the marginal investor determine the equilibrium stock price. Market equilibrium occurs when the stock's price is (PICK ONE: less than, equal to, greater than) its intrinsic value. If the stock market is reasonably efficient, differences between the stock price and intrinsic value should not be very large and they should not persist for very long. When investing in common stocks, an investor's goal is to purchase stocks that are undervalued (the price is (PICK ONE: above, below, equivalent to) the stock's intrinsic value) and avoid stocks that are overvalued.

The value of a stock today can be calculated as the present value of (PICK ONE: a finite, an infinite) stream of dividends:

This is known as the constant growth model or Gordon model, named after Myron J. Gordon who developed and popularized it. There are several conditions that must exist before this equation can be used. First, the required rate of return, r_s, must be greater than the long-run growth rate, g. Second, the constant growth model is not appropriate unless a company's growth rate is expected to remain constant in the future. This condition almost never holds for (Pick One: Mature, Start-up) firms, but it does exist for many (Pick One: Mature, Start-up) companies.

Which of the following assumptions would cause the constant growth stock valuation model to be invalid?

1. The growth rate is zero.
2. The growth rate is negative.
3. The required rate of return is greater than the growth rate.
4. The required rate of return is more than 50%.
5. None of the above assumptions would invalidate the model.

(Pick One statement above)

Answer 1

Market equilibrium occurs when the stock's price is equal to its intrinsic value

When investing in common stocks, an investor's goal is to purchase stocks that are undervalued (the price is below the stock's intrinsic value) and avoid stocks that are overvalued.

The value of a stock today can be calculated as the present value of an infinite stream of dividends:

his condition almost never holds for start-up firms, but it does exist for many Mature companies

Which of the following assumptions would cause the constant growth stock valuation model to be invalid?

None of the above assumptions would invalidate the model.

Explanation: This is because, the formula holds for growth equals to zero, and also when growth rate is negative. Gordon growth model is true even for a condition when required rate of return is greater than the growth rate and also when required rate of return is very high. Therefore, none of the options above is invalid.

Constant growth model is not applicable only when required rate of return is less than the growth rate when the price becomes negative.