CFA Examination Level I (adapted)

Mulroney recalled from her CFA studies that the constant-growth dividend discount model (DDM) was one way to arrive at a valuation for a company’s common stock. She collected current dividend and stock price data for Eastover and Southampton, shown in Table 2.

a. Using 11 percent as the required rate of return (i.e., discount rate) and a projected growth rate of 8 percent, compute a constant-growth DDM value for Eastover’s stock and compare the computed value for Eastover to its stock price indicated in Table 2. Show calculations. Mulroney’s supervisor commented that a two-stage DDM may be more appropriate for companies such as Eastover and Southampton. Mulroney believes that Eastover and Southampton could grow more rapidly over the next three years and then settle in at a lower but sustainable rate of growth beyond 2004. Her estimates are indicated in Table 3.

b. Using 11 percent as the required rate of return, compute the two-stage DDM value of Eastover’s stock and compare that value to its stock price indicated in Table 2. Show calculations.

c. Discuss two advantages and three disadvantages of using a constant-growth DDM. Briefly discuss how the two-stage DDM improves upon the constant-growth DDM.