Stock Valuation Exam Training
Exam questions on stock valuation rarely stop at one formula. A common twist is nonconstant growth: dividends grow fast for a few years, then settle into steady growth. You discount the early dividends one by one, use the Gordon model for the rest, and add it all up.
What you will learn
- How to spot which stock valuation model a question needs
- How to value a stock with nonconstant (supernormal) growth
- Where to place the Gordon growth price on the timeline
- Common exam traps: D₀ versus D₁, and discounting the wrong year
The formulas
- D₁ to D_N
- Dividends during the high-growth years
- P_N
- Price at year N, when constant growth begins
- r
- Required return
- D_(N+1)
- First dividend of the constant-growth phase
- g
- Long-run constant growth rate
Worked example
A firm just paid a $1.00 dividend. Dividends will grow 20% a year for two years, then 5% a year forever. The required return is 12%. What is the stock worth today?
- D₁ = 1.00 × 1.20 = 1.20; D₂ = 1.20 × 1.20 = 1.44
- D₃ = 1.44 × 1.05 = 1.512
- P₂ = 1.512 ÷ (0.12 − 0.05) = 21.60
- P₀ = 1.20 ÷ 1.12 + (1.44 + 21.60) ÷ 1.12² ≈ 1.0714 + 18.3673
- P₀ ≈ 19.44
Answer: The stock is worth about $19.44 (rounded to the nearest cent).
Common questions
How do you value a stock with nonconstant growth?
Write out each dividend during the fast-growth years. At the year when steady growth starts, use the Gordon model to find the price at that point. Then discount every early dividend and that future price back to today and add them up.
Why is the Gordon growth price discounted from year N and not year N + 1?
The Gordon formula P_N = D_(N+1) ÷ (r − g) gives a price one year before the dividend it uses. So a price built from D₃ is a Year 2 value and you discount it for two years. This is the single most common error on these problems.
How do I find the required return on a stock for an exam?
If the question gives price, next dividend and growth, use r = D₁ ÷ P₀ + g. If it gives a beta, a risk-free rate and a market return, use CAPM instead. Read the question for which pieces of data you actually have.
What is the best way to practice stock valuation problems?
Draw a timeline for every question, mark each dividend in the year it is paid, and label where any terminal price sits. Then solve problems of each type: zero growth, constant growth, nonconstant growth and solving for r, until the setup becomes automatic.