Which formula represents the price of a stock under the Gordon Growth Model?

• A. D1 / (r - g)
• B. D0 / (r - g)
• C. D1 * (1 + g) / (r - g)
• D. D1 / (r + g)

Answer: (A)

This question tests how the Gordon Growth Model values a stock, using the idea that dividends grow at a constant rate forever and investors require a return r. In this model, the stock price today is the present value of an infinite series of dividends that grow by g each period. The formula is P0 = D1 / (r − g), where D1 is the dividend expected next year, r is the required return, and g is the constant growth rate of dividends (with r > g for the value to converge).

So the correct expression uses D1 in the numerator and r minus g in the denominator, which is why D1 / (r − g) is the right form.

Using D0 / (r − g) would ignore the fact that the next-period dividend is D1, not the most recent payment, and it wouldn’t properly account for the growth to that next dividend. Using D1 * (1 + g) / (r − g) would be D2 / (r − g), which overstates the value. Using D1 / (r + g) uses the wrong sign in the denominator.