The market consensus is that Analog Electronic Corporation has an ROE = 6% and a
ID: 2758062 • Letter: T
Question
The market consensus is that Analog Electronic Corporation has an ROE = 6% and a beta of 1.30. It plans to maintain indefinitely its traditional plowback ratio of 1/3. This year's earnings were $3.0 per share. The annual dividend was just paid. The consensus estimate of the coming year's market return is 15%, and T-bills currently offer a 5% return. Find the price at which Analog stock should sell. (Do not round intermediate calculations. Round your answer to 2 decimal places.) Calculate the P/E ratio. (Do not round intermediate calculations. Round your answers to 2 decimal places.) Calculate the present value of growth opportunities. (Negative amount should be indicated by a minus sign. Do not round intermediate calculations. Round your answer to 2 decimal places.) Suppose your research convinces you Analog will announce momentarily that it will immediately reduce its plowback ratio to 2/3. Find the intrinsic value of the stock. (Do not round intermediate calculations. Round your answer to 2 decimal places.)Explanation / Answer
Expected Return on equity as CAPM:
5% + 1.30(15% - 5%) = 18%
Plowback ratio = 1 – (Annual Dividend Per Share / Earnings Per Share)
1/3 = 1 – (Annual Dividend per share / $3.0)
Annual Dividend per Share = $2.0
Sustainable Growth Rate = ROE * Plowback Ratio
=> 6% * 33.33% = 2%
Price of the stock = Dividend / (Ke – G) => $2.0/(18% - 2%) = $12.5
P/E Ratio = $12.5/$3.0 = 4.167
Present Value of Growth Opportunities = ROE – Required Rate of return
=> 6% - 18% = -12%
Intrinsic value of the stock with decreased plow back:
Plowback ratio = 1 – (Annual Dividend Per Share / Earnings Per Share)
2/3 = 1 – (Annual Dividend per share / $3.0)
Annual Dividend per Share = $1.0
Sustainable Growth Rate = ROE * Plowback Ratio
=> 6% * 66.67% = 4%
Intrinsic Value of the stock = Dividend / (Ke – G) => $1.0/(18% - 4%) = $7.14
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