# Equity Discount Model WTF?

Here is the question from Qbank: Which of the following DDMs assumes a high growth rate during the initial stage, followed by a linear decline to a lower stable growth rate? a) Three-stage DDM b) Gordon growth model c) H model I am pissed about the correct answer which I will give once I get some replies and justifications. I will also provide the justification for why I answered the way I did (mine comes from the CFA texts, not the stupid ass Schweser material). I’m pissed because I seem to be noticing many such minute inconsistencies. What say ye?

C

C

C? am i missing something?

C

linear declining in H-model.

c.

C

C

Well I guess I am retarded. I answered A. Here is my reasoning: Stage 1: “high growth rate during the initial stage” Stage 2: and we know this is the next stage since it says “followed by,” “followed by a linear decline to a lower stable growth rate” Stage 3: terminal value computed at the aforementioned stable growth rate According to the CFA texts, Bk. 4 top of page 319, this is a second variation of the three stage model (which is why I answered the way I did). In the H model the decline from the high growth rate to the stable growth rate occurs immediately (i.e. over the first stage). Hence, the structure of this question makes this an impossibility since it states that only after the initial high growth stage does the growth rate decline linearly to the stable rate. Help me out guys am I really that stupid?

C

Yea I know the answer is C, Qbank told me that much. I am more interested in your justification, particularly in comparison to mine, as to why its C and not A. Anyone?

3 stage DDM is an immediate drop from a Hi->Transition->Stable growth phases. It says High phase 20% for 2 years, then growth at 10% for 3 years. After that Stable is for 3 years @ 5%. --> three stage DDM For the H-Model-> High growth 20% for 2 years. Stable is 5% for 3 years. There is a steady decline from 20% to 5% over 3 years…

@cpk: right the three stage model you describe is the first variation explained by the CFAI texts (its in book 4 page 318). The second variation however is described on page 319 as follows: “A second variation of the three-stage DDM has a MIDDLE stage similar to the FIRST stage in the H-model…In the second stage, dividends decline linearly as they do in the H-model.” Anyone else have any thoughts?

Can the 3 stage DDM have rates which are not decreasing… Some thing like 10 in the first stage, 15 in the second and 5 in the third? Does it mandate that growths in different stages to decline? I remember this was one question from q bank.

Dax2IB Wrote: ------------------------------------------------------- > Some thing like 10 in the first stage, 15 in the > second and 5 in the third? Does it mandate that > growths in different stages to decline? A legitimate scenario.

C, because of linear decline from high growth to slow growth. I can see why you would think it would be A but lets say its a linear line of 1% over 5 years then you would technically have a 8 stage DDM because each year would its own multistage phase. But just remember linear decline from high to low is H-model.

Question seems to imply only two stages. First High Growth, then drop to a stable.

@dax: yes that is one variation of the three stage model for sure @Bipolar: I don’t understand what you mean by “lets say its a linear line of 1% over 5 years then you would technically have a 8 stage DDM because each year would its own multistage phase” based on what the CFAI texts say a 3 stage model can have a middle stage that is like the first stage of an H model, which based on the wording of this question seems to be the case. @jdane: How do you figure? It seems to me that the question indicates clearly that the period of linear decline in the growth rate FOLLOWS the period of high growth. If this is in fact the case I have no problem with C and would have in fact answered C. But it seems to me that the wording would imply three stages (again, this is why I hate Qbank it is vary loose with language (i.e. I know what they are trying to say and hence the correct answer that they are looking for but if I formally read the question and ascribe to the CFAI view of the facts then I get a different answer, which is usually not included thereby making life somewhat easier) and very ambiguous at times). I think I may be over-reading here also but based on the scenario that they provide the correct answer (although not the one they are seeking, aka A) is included in the answer choices thereby compelling me to choose it over the one they deem correct (aka H Model).

Lets say you have growth of 5% for 2 years then a straight decline to 2% constant growth forever. Thats a straight up 2 stage DDM. or you have growth of 5% for 2 years then a linear decline to 2% over the next 3 years. Then 2% growth forever. Stage 1: 5% for 2 years Stage 2: 4% for 1 year Stage 3: 3% for 1 year Stage 4: 2% for 1 year Stage 5: 2% forever. so a linear decline DDM is really a multistage but the H-model simplify it into one stage.