Ironore Limited is an iron mining company whose mines are slowly being depleted

Question

Ironore Limited is an iron mining company whose mines are slowly being depleted (i.e., little by little, the amount of iron ore available in the mine is declining as the ore is extracted each year). Therefore, investors expect Ironore’s Net Income to decline each year by 2%. Ironore’s most recent Net Income = $2 million, and there are 500,000 shares of Ironore common stock outstanding. Ironore pays out all of its Net Income as dividends to its shareowners. What is your estimate of Ironore’s Price/Earnings ratio (i.e., ratio of stock price to earnings per share)? Assume investors require a minimum rate of return = 10% on an investment in Ironore stock.

Explanation / Answer

The EPS of the share is 2,000,000/500,000 = $4/share

Now according to dividend growth model,

Ke = D1/P0 +g

Given minimum rate of return = ke = 10% =0.10

D1 dividend next year = 4*(1-0.02) = 3.92. Since the earnings rediuce by 2% and entire earnings are paid as dividends, the dividends also will reduce by 2%

g = -0.02 since there negative growth

Hence in the above formula, 0.10 = 3.92/P0 -0.02

P0 = 3.92/0.12 = 32.67

Hence current stock price is $32.67

Now the Price/Earnings ratio will be Current stock price/EPS = 32.67/4 = 8.167

Related Questions

Navigate

• Browse (All)
• Browse I
• Subjects

Integrity-first tutoring: explanations and feedback only — we do not complete graded work. Learn more.