If we divide each side of the equation by the firm’s earnings per share, we arri

Question

If we divide each side of the equation by the firm’s earnings per share, we arrive at a P/E ratio for which we could use to compare firms which have similar P/E multiples. However, this begs the question of just how comparable these firms are to each other. Explain how each of those determinants plays a part across supposedly similar firms.

-What are the components of the required rate of return on a share of stock? Briefly explain each component.

-Suppose we consider a firm with positive net present value of growth opportunities. We saw that the price of the stock could be expressed as follows:

P=EPS/i + NPVGO

Explanation / Answer

P=D1/(r-g)/E

1. COst of equity might not be the same across comparable firms because of different beta (diff capital structure, operating leverage, etc.)

Growth opportunities might be different
Dividend Payout ratio might not be the same
2.
required return depends on the market risk premium, risk free rate, beta (which is dependent on the capital structure)

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