Chartered Financial Analyst (CFA) Practice Exam Level 2

How is the required rate of return represented in the Gordon Growth Model?

1. r = (D1 / P0) - g

2. r = (D1 / P0) + g

3. r = D1 / (P0 * g)

4. r = g + P0 / D1

The correct answer is: r = (D1 / P0) + g

In the Gordon Growth Model, the required rate of return (r) is calculated using the formula r = (D1 / P0) + g. Here, D1 represents the expected dividends for the next period, P0 is the current price of the stock, and g is the constant growth rate of the dividends. This formulation breaks down into two components: the first part, (D1 / P0), gives the dividend yield, which is the return generated from dividends relative to the price paid for the stock. The second part, g, accounts for the capital gains expected from the growth of the dividends over time. By combining these two parts, the formula provides a comprehensive view of the total expected return from investing in a stock that pays dividends and is expected to grow their dividends at a constant rate. When investors use the Gordon Growth Model, they are typically assessing the attractiveness of a stock based on its expected future cash flows (in the form of dividends), relative to its current valuation. This model is especially useful for valuing companies that pay stable and predictable dividends, as it assumes a constant growth rate for dividends, which simplifies the analysis. Understanding the model can help investors make informed decisions about whether a stock's current price reflects a