Over the past few years, Comapany has retained on average 70% of its earnings in
ID: 2383096 • Letter: O
Question
Over the past few years, Comapany has retained on average 70% of its earnings in the business. The future retention rate is expected to remain at 70% of earnings and the long-run earnings growth is expected to be 10%. If the risk free rate kRF is 8%, the expected return on the market, km is 12%. Company A's beta is 2.0 and the most recent dividen, D0, was $1.50. What is the most likely market price and P/E ratio for Comapany A's stock today. (hint: Start by finding the required rate of return for Company A's investors)
Explanation / Answer
Over the past few years, Comapany has retained on average 70% of its earnings in the business. The future retention rate is expected to remain at 70% of earnings and the long-run earnings growth is expected to be 10%. If the risk free rate kRF is 8%, the expected return on the market, km is 12%. Company A's beta is 2.0 and the most recent dividen, D0, was $1.50. What is the most likely market price and P/E ratio for Comapany A's stock today. (hint: Start by finding the required rate of return for Company A's investors)
As per CAPM
Required rate of return = risk free rate kRF + (expected return on the market, km - risk free rate kRF)*beta
Required rate of return = 8 + (12-8)*2
Required rate of return = 16%
Expected Dividend (D1) = D0*(1+g)
Expected Dividend (D1) = 1.50*(1+10%)
Expected Dividend (D1) = 1.65
Market price for Company A's stock today = Expected Dividend (D1) /( Required rate of return - g)
Market price for Company A's stock today = 1.65/(16%-10%)
Market price for Company A's stock today = $ 27.50
Current Dividend = 1.50
Current EPS = Current Dividend /(1-retention ratio)
Current EPS = 1.50/(1-0.7)
Current EPS = 5
P/E ratio for Company A's stock today = Market price for Comapany A's stock today / Current EPS
P/E ratio for Company A's stock today = 27.50/5
P/E ratio for Company A's stock today = 5.5 Times
Answer
Market price for Company A's stock today = $ 27.50
P/E ratio for Company A's stock today = 5.5 Times
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