Share repurchases and Gordon Growth Model?

CFA Level II Equities
#1

Hello,

In the Official CFA Curriculum for Level 2, 2018, Reading 30, Practice Problems, there is questions number 49, which aks:

Which sector report best describes a situation in which the Gordon growth model could be used to value utility stocks?

  1. Report 1
  2. Report 2
  3. Report 3
  • Report 1: A resurgence in domestic manufacturing activity will generate long-term growth in earnings and dividends that exceeds the cost of equity.
  • Report 2: Share repurchases are expected to increase. The report expresses confidence in the forecasts regarding the magnitude and timing of these repurchases.
  • Report 3: The report forecasts earnings growth of 4.5%. The key growth drivers are increases in population and business creation associated with stable GDP growth of 2.75%.

B is correct because the Gordon growth model can accurately value companies that are repurchasing shares when the analyst can appropriately adjust the dividend growth rate for the impact of share repurchases.

(Institute 265)

Institute, CFA. 2018 CFA Program Level II Volume 4 Equity. CFA Institute, 07/2017. VitalBook file.

Why is it not Report 3?

#2

It’s not 3 because long-term growth of a company or industry cannot exceed the long-term growth rate of the economy.

1 Like
#3

Oh, that makes sense!

QQ!

#4

I’m allowed to make sense only once a week.

You got lucky.

You’re quite welcome.

#5

Is Report 2 also the right answer because, considering if RoE < Cost of Equity, the firm would have had to likely issue new equity. And the fact that Share Repurchases are happening likely indicates that RoE > Cost of Equity.

I don’t think I fully understand how the fact that Share Repurchases are occurring/and going to consistently occur in the future indicates a constant growth in Dividends (for the GGM to be applied correctly)

Is it because the company would require sufficient Retained Earnings to conduct buybacks, and this itself shows that they have enough for dividends as well?