Constant growth model assumes.
Multiple Choice
Choose the correct option:
a. P/E ratio is constant.
b. Dividend growth is constant.
c. Dividend yield is constant.
d. A firm’s sale growth is constant.
The correct answer and explanation is :
Correct Answer: b. Dividend growth is constant.
Explanation (300 words):
The Constant Growth Model, also known as the Gordon Growth Model (GGM), is a popular method used to value a stock based on the assumption that dividends will increase at a constant rate indefinitely. This model is primarily applied to companies that are stable and have predictable dividend growth patterns.
The formula for the Constant Growth Model is:
[
P_0 = \frac{D_1}{r – g}
]
Where:
- ( P_0 ) = Current stock price
- ( D_1 ) = Dividend expected next year
- ( r ) = Required rate of return
- ( g ) = Constant growth rate of dividends
This model hinges on option (b): “Dividend growth is constant.” This means that each year, the company is expected to increase its dividend payout at a steady, unchanging rate. This assumption simplifies the process of valuing a company’s stock and makes it easier for investors to estimate future income from dividends.
Let’s examine the incorrect choices:
- (a) P/E ratio is constant: While the price-to-earnings (P/E) ratio may be influenced by growth expectations, it is not assumed to be constant in the constant growth model.
- (c) Dividend yield is constant: Dividend yield ((D/P)) may change as the stock price changes, even if dividends grow at a constant rate. Hence, it is not assumed to be constant.
- (d) A firm’s sales growth is constant: Sales growth can impact overall business performance, but the constant growth model specifically concerns dividends, not revenue or sales.
In conclusion, the core assumption of the constant growth model is that dividends will grow at a constant rate. This model is most suitable for companies with a stable dividend history and modest, predictable growth.