ACCA Financial Management (F9) Certification Practice Exam

Which component is NOT part of the Dividend Growth Model formula?

1. Current market price

2. Cost of equity

3. Expected dividends

4. Dividend payout ratio

The correct answer is: Dividend payout ratio

The Dividend Growth Model, also known as the Gordon Growth Model, is designed to determine the present value of a stock based on the dividends it is expected to pay in the future. The formula for this model includes three critical components: 1. **Current market price** - This reflects the price of the stock in the market at the time of evaluation. 2. **Cost of equity** - This represents the required return necessary to make an investment in the stock worthwhile, effectively capturing the idea of risk and opportunity cost. 3. **Expected dividends** - This represents the future cash flows an investor anticipates receiving from the stock, typically expressed in terms of expected growth over time. The dividend payout ratio, while vital in analyzing a company's earnings retention and future growth potential, does not appear directly in the Dividend Growth Model formula. Instead, it helps understand how much of the earnings are distributed as dividends versus what is retained for reinvestment. However, the formula itself is concerned only with the expected dividends expected to grow at a constant rate and relates these dividends to the current market price and cost of equity. This is why the dividend payout ratio is not considered a part of the Dividend Growth Model formula.