CFA Level II · CFA Level II Exam

Discounted Dividend Valuation for CFA Level II

Q: Which dividend discount model should I use in the exam?

Choose by the growth pattern in the vignette. Use Gordon growth for stable, constant growth, and a multistage model when growth will change. Use the H-model only when growth is described as declining steadily from a high rate to a long-run rate.

Q: How do I find implied required return from a share price?

With constant growth, rearrange the Gordon model to r = D1 ÷ P0 + g. With multistage dividends, find the discount rate that makes the present value of the dividends and terminal value equal the price. Use the answer choices to test values if the question allows.

Q: What does PVGO tell me?

PVGO is the part of a share's value that comes from expected growth opportunities beyond the no-growth value. It equals the share value minus E1 ÷ r. A large PVGO relative to price means the market relies heavily on future growth.

Q: Do I need to memorise the sustainable growth rate formula?

Yes. Use g = b × ROE, where b is the retention rate. It helps you test whether a given growth rate is consistent with the company's payout and returns, and it often supplies the growth input directly.

Discounted dividend valuation values a share as the present value of expected future dividends, discounted at the required return on equity. To solve it, pick the right model (Gordon growth, multistage, or H-model), check that growth is below the required return, discount each stage correctly, then add the terminal value.

What this chapter covers

This chapter is about one idea: a share is worth the present value of the cash it pays you. The dividend discount model (DDM) turns that idea into formulas. You start with the general multi-period model, then move to the Gordon growth model for a stable, constant-growth company, and then to multistage models for companies whose growth will change over time.

Along the way you learn to split value into two parts: the value of the existing business with no growth, and the present value of growth opportunities (PVGO). You also link growth to fundamentals using the sustainable growth rate: g = b × ROE, where b is the earnings retention rate. This lets you test whether a growth forecast is realistic. The last part reverses the process: given a market price, you solve for the implied required return, and you adapt the DDM for companies that pay no dividends or are spun off.

This chapter is the base of the Equities topic. Later chapters on free cash flow and residual income use the same discounting logic and the same terminal-value thinking. It also connects to Corporate Finance (dividend policy, payout, ROE) and Financial Statement Analysis (ROE drivers). At Level II, questions sit inside an item set, so you must pull dividends, growth, retention, and required return out of a vignette and apply the right model.

Equities is one of the larger topics in the paper, and dividend discount models are the foundation for the valuation methods that follow. The maths is short, so this chapter is a place to collect reliable points if you are careful with timing, growth conditions, and which dividend you are using. The same skills (terminal value, implied return, growth from fundamentals) come back in other equity valuation chapters, so time spent here pays off several times in the exam. There is no penalty for wrong answers, but sloppy timing errors lose points that are easy to win.

Discounted Dividend Valuation: topics in the order to study them

1Dividend Discount Model BasicsIt sets out the general model, the holding-period logic, and the discounting conventions every later model builds on.
2Gordon Growth ModelIt is the simplest closed-form case, and it gives you the terminal-value formula used in multistage models.
3Sustainable Growth Rate and Dividend GrowthIt teaches where g comes from (retention and ROE), which you need before judging any growth input.
4Present Value of Growth OpportunitiesIt uses Gordon growth and a no-growth value, so it is easier once both are clear.
5Multistage Dividend Discount ModelsIt combines everything above: explicit-period dividends, a terminal value, and growth that changes.
6Estimating Required Return and Implied ReturnIt reverses the models to solve for the return, which is easiest once you can value a share forward.
7Valuing Non-Dividend-Paying and Spin-off SituationsIt is an application of the earlier models to special cases, so it comes last.

How to prepare Discounted Dividend Valuation

Aim to be fast and exact. Most marks are lost on setup, not on arithmetic, so practise reading a vignette and identifying the inputs.

Learn each formula with its conditions. For Gordon growth, V0 = D1 ÷ (r − g), valid only when g < r and growth is stable. Note that D1 is the next dividend, not the last one.
Practise timing. Write a timeline for every problem: mark which dividend is D0, D1, and where the terminal value sits (the value at time n uses Dn+1).
Work the growth link: g = b × ROE, with b = 1 − payout ratio. Practise going both ways, from payout and ROE to g, and from g back to the implied payout or ROE.
Solve PVGO questions in two steps: no-growth value = E1 ÷ r, then PVGO = V0 − E1 ÷ r. Check the result is sensible against the share price.
Build multistage problems in layers: discount each explicit dividend, compute the terminal value with Gordon growth, discount it back, and add. Do several with two and three stages.
For implied return, rearrange the model: with Gordon growth, r = D1 ÷ P0 + g. For multistage cases, expect trial and error or a given choice of answers, and test the options against the price.
Finish with timed item sets. Practise finding the data fast in the vignette and ignoring distractors such as unrelated exhibit figures.

Common mistakes in Discounted Dividend Valuation

Using D0 instead of D1 in the Gordon growth formula.
Fix: Always ask which dividend is given. If it is D0, multiply by (1 + g) first. Write D1 on your scratch line before you divide.
Applying the Gordon growth model when g is not below r, or when growth is not stable.
Fix: Check g < r and that growth can plausibly continue indefinitely. If growth will change, move to a multistage model.
Discounting the terminal value by the wrong number of periods.
Fix: Draw a timeline. The terminal value at the end of year n is discounted n years, the same as the year-n dividend.
Confusing the retention rate with the payout ratio in g = b × ROE.
Fix: Remember b is the share of earnings kept. If payout is 40%, b = 60%. Check that your g is realistic.
Computing PVGO from the wrong earnings figure.
Fix: The no-growth value is E1 ÷ r, so use next year's expected earnings E1, and compare it with V0, today's value. If only E0 is given and no growth is assumed, E1 = E0. Write which figure you use before you divide.
Stopping after the arithmetic without a sense check of the answer.
Fix: Compare your value or implied return with the inputs. A required return below the growth rate, or a value far from the market price without reason, signals an error.

Last-day revision: Discounted Dividend Valuation

General DDM: value = present value of all expected future dividends discounted at the required return on equity.
Gordon growth: V0 = D0 × (1 + g) ÷ (r − g) = D1 ÷ (r − g). It needs g < r and stable growth.
Terminal value at time n = Dn+1 ÷ (r − g). Discount it back n periods.
Implied return under Gordon growth: r = D1 ÷ P0 + g.
Sustainable growth: g = b × ROE, where b = 1 − dividend payout ratio.
No-growth value per share = E1 ÷ r; PVGO = V0 − E1 ÷ r.
Justified leading P/E = (1 − b) ÷ (r − g); justified trailing P/E = D0 × (1 + g) ÷ (E0 × (r − g)), which equals (1 − b) × (1 + g) ÷ (r − g).
Higher growth or a lower required return raises value, and value is very sensitive as r − g shrinks.
Multistage models: explicit dividends in the high-growth stage, then a terminal value from a stable-growth stage.
The H-model approximates a linear decline in growth from a high rate to a long-run rate; it is an approximation, not an exact value.
For non-dividend payers, value using expected future dividends once payments begin, or use other methods when dividends are not a good guide to value.
Always check the units and timing: annual versus quarterly dividends, and whether the vignette gives D0 or D1.

Discounted Dividend Valuation in other exams

The same ground in other exams, if you are preparing for more than one or want another angle on it.

Discounted Dividend Valuation: frequently asked questions

Which dividend discount model should I use in the exam?

Choose by the growth pattern in the vignette. Use Gordon growth for stable, constant growth, and a multistage model when growth will change. Use the H-model only when growth is described as declining steadily from a high rate to a long-run rate.

How do I find implied required return from a share price?

With constant growth, rearrange the Gordon model to r = D1 ÷ P0 + g. With multistage dividends, find the discount rate that makes the present value of the dividends and terminal value equal the price. Use the answer choices to test values if the question allows.

What does PVGO tell me?

PVGO is the part of a share's value that comes from expected growth opportunities beyond the no-growth value. It equals the share value minus E1 ÷ r. A large PVGO relative to price means the market relies heavily on future growth.

Do I need to memorise the sustainable growth rate formula?

Yes. Use g = b × ROE, where b is the retention rate. It helps you test whether a given growth rate is consistent with the company's payout and returns, and it often supplies the growth input directly.