Chartered Financial Analyst (CFA) Practice Exam Level 2

What is the expected capital gains yield of a fairly priced stock?

1. It is equal to the dividend paid

2. It corresponds to the rate of inflation

3. It is equal to the expected dividend growth rate

4. It represents the total market return

The correct answer is: It is equal to the expected dividend growth rate

The expected capital gains yield of a fairly priced stock is equal to the expected dividend growth rate because it reflects how much the stock's price is anticipated to increase over time, assuming that the stock remains fairly priced. In a well-functioning market, a stock's price should grow at the same rate as the dividends it generates, as investors will value the stock based on the future cash flows it is likely to provide. Hence, if a company's dividends are expected to grow at a certain rate, investors will inherently expect the price of the stock to increase at the same rate, resulting in a corresponding capital gains yield. This principle is rooted in the Gordon Growth Model, which links stock price and dividends. When analysts evaluate a stock, they often consider the anticipated growth in dividends, as this growth is a fundamental driver of long-term stock price appreciation. Therefore, if a stock is fairly priced, the expected capital gains yield will directly match the expected rate of growth in dividends, making this option the right choice.