(Relative valuation of common stock)Using the P/E ratio approach to valuation, c
ID: 2739728 • Letter: #
Question
(Relative valuation of common stock)Using the P/E ratio approach to valuation, calculate the value of a share of stock under the following conditions:
• the investor's required rate of return is 15 percent, • the expected level of earnings at the end of this year (Upper E 1E1) is $5, • the firm follows a policy of retaining 40 percent of its earnings, •the return on equity (ROE) is 12 percent, and • similar shares of stock sell at multiples of 5.882 times earnings 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 pice using the dividend discount model is $ _____. (Round to the nearest cent.)
Explanation / Answer
(a)
Calculation of stock price using P/E ratio valuation:
Market price = Earnings * multiplier
Market price = 5.882 * $5 = $29.41
Therefore, the stock price is $29.41.
(b)
Calculation of stock price using dividend discount model:
= $5 *(1-0.40) / 0.12
= $25
Therefore, the stock price is $25.
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