Chartered Financial Analyst (CFA) Practice Exam Level 2

What is a common limitation of the Gordon Growth Model?

1. It assumes high growth for all companies

2. It does not account for market conditions

3. It is not suitable for non-dividend stocks

4. It requires a high level of share price volatility

The correct answer is: It is not suitable for non-dividend stocks

The Gordon Growth Model, also known as the Dividend Discount Model, fundamentally relies on the premise that a company will continue to pay dividends that grow at a constant rate indefinitely. This implicit requirement means that the model is inherently unsuitable for valuing companies that do not pay dividends, such as start-ups or firms in growth phases that reinvest profits rather than distribute them to shareholders. For these non-dividend-paying stocks, the model cannot generate a meaningful value, as it is anchored on anticipated future dividends. Other options present alternative common misconceptions surrounding the model, but they do not accurately reflect its most significant limitation. For example, it does not assume high growth for all companies; rather, it assumes a constant growth rate that can be low or moderate. Additionally, while market conditions may affect stock prices, the Gordon Growth Model does not specifically factor in these conditions beyond its focus on dividends. Lastly, the model does not require a high level of share price volatility; in fact, it's often used for stable, mature companies with predictable dividend streams. Understanding these nuances is key to effectively applying the Gordon Growth Model in practice.