ICMAB Stock Valuation Study Guide

A Focused Approach to Mastering Key Concepts for Your Exam

High-Priority Concepts

1. Dividend Discount Models (DDM)

This is the cornerstone of stock valuation and the most frequently tested area. Master all three variations to handle any problem type.

  • Zero-Growth Model: For stocks with constant dividends.
    $$ P_0 = \frac{D}{R} $$
  • Constant Growth Model (Gordon Growth Model): For stocks with dividends growing at a steady rate forever.
    $$ P_0 = \frac{D_1}{R-g} = \frac{D_0(1+g)}{R-g} $$
  • Nonconstant Growth Model: For stocks with a period of "supernormal" growth that transitions to constant growth. This requires a two-step approach: valuing the initial dividends and then finding the present value of the terminal stock price.

2. Required Return & Yields

Understand that total return is composed of two key parts.

  • Total Required Return: The return an investor expects for a given level of risk.
  • Dividend Yield: The return from the dividends received, calculated as $\frac{D_1}{P_0}$.
  • Capital Gains Yield: The return from the stock's price appreciation, which in the constant growth model is equal to the growth rate, $g$.
  • Formula:
    $$ R = \frac{D_1}{P_0} + g $$

3. Integrating CAPM & DDM

Be ready for problems that use the Capital Asset Pricing Model (CAPM) to find the required return ($R$), which you then use in the DDM to find the stock price. This is a common and challenging question format.

$$ R = R_f + \beta \times (R_M - R_f) $$

High-Priority Problems & Tricky Areas

Tricky Area 1: D0 vs. D1

Always double-check if the dividend given is the one that was just paid (D0) or the one to be paid next year (D1). If it's D0, you must calculate D1 by growing it by the rate g.

Tricky Area 2: The Terminal Price

In a nonconstant growth problem, the terminal stock price (Pt) is calculated using the first dividend of the constant growth phase (Dt+1). This is a common mistake. Remember, the price at a given time depends on the cash flow of the next period.

Tricky Area 3: Required Return vs. Growth Rate

The DDM requires that the required return (R) is always greater than the growth rate (g). If this condition is not met, the model breaks down and yields a nonsensical result.

Practice Area: High-Priority Problems

Integrated CAPM & DDM

Sorbond Industries has a beta of 1.45. The risk-free rate is 8 percent, and the expected return on the market is 13 percent. The company just paid a dividend of Tk. 2 a share, and investors expect it to grow by 10 percent per annum for many years to come.

  • What is the stock's required rate of return according to the CAPM?
  • What is the stock's present market price per share?

Two-Stage Growth

Newline Plc. is expected to pay equal dividends at the end of each of the next two years. Thereafter, the dividend will grow at a constant annual rate of 3.5 percent forever. The current stock price is $59. What is next year's dividend payment if the required rate of return is 11 percent?

Conceptual Challenge

In the context of the dividend growth model, is it true that the growth rate in dividends and the growth rate in the price of the stock are identical? Explain why or why not.