Question

1. When would it be important to AVOID using the Gordon growth model (also called the dividend discount model) to estimate the value of common stock in a future period?

1. The required return on the stock is 5 percent and the expected dividend growth rate is 6 percent.
2. There is an expectation that the dividend growth rate will continue indefinitely.
3. The only reliable information available is the current dividend paid, the expected dividend growth rate, and the required return on common equity.
4. An investor believes the future dividend growth will 2 percent even though the capital market consensus is for 4 percent.

Answer 1

As per Gordon Model, Value of stock = Expected Dividend next year/(Required rate of return - Growth rate)

The model provides negative value for the stock when the expected growth rate is higher than the required rate of return

and hence cannot be used in such circumstances

Hence, the answer is

a. The required return on the stock is 5 percent and the expected dividend growth rate is 6 percent.

It can be used in rest of the cases