Using the P/E ratio approach to valuation, calculate the value of a share of sto

ID: 2383708 • Letter: U

Question

Using the P/E ratio approach to valuation, calculate the value of a share of stock under the following conditions:

- the investors required rate of return 14%

-the expected level of earning at the end of the year (E1) is $5

-the firm follows a policy of retaining 40% of it's earnings.

-the return on equity (ROE) is 15%, and

-similar shares of stock sell at multiples of 7.500 times earning per share.

now show that you get the same answer using the discounted dividend model.

a. the stock price using the P/E ratio valuation method is $________ (round to the nearest cent.)

b. The stock price using the dividend discount model is $_________ (round to the nearest cent.)

a. P/E = 7.5x

The price of the stock = P/E * Earning per share

= 7.5 * $5

= $37.50 ~ $38

b. Retention ratio, b = 40% or 0.4

Dividend growth rate, g = b * ROE

= 0.4 * 15%

= 6%

Storck price = Dividend next at year end / (Investor required return - Dividend growth rate)

= $5 * (1 - 40%) / (14% - 6%)

= $37.50 ~ $38

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