One of the most important components of stock valuation is a firm\'s estimated g

Question

One of the most important components of stock valuation is a firm's estimated growth rate. Financial statements provide the information needed to estimate the growth rate. Consider this case: Robert Gillman, an equity research analyst at Gillman Advisors, believes in efficient markets. He has been following the mining industry for the past 10 years and needs to determine the constant-growth rate that he should use while valuing Pan Asia Mining Co. Pan Asia Mining Co.'s stock (Ticker: PAMC) is trading at $15.00. The company has forecasted net income and book value of equity for the coming year to be $946,800 and $7,410,000, respectively. The company has also been paying dividends for the past 8 years and has maintained a dividend payout ratio of 30.00%. Based on this information, Robert's forecast of PAMC's growth rate in earnings and dividends should be: 19.17% 5.75% 12.78% 8.94% o Which of the following statements accurately describes the relationship between earnings and dividends when all other factors are held constant? Growth in earnings requires growth in dividends. Retaining a higher percentage of earnings will result in a higher growth rate. Long-run earnings growth occurs primarily because firms pay dividends to reward their shareholders for investing in the company.

Explanation / Answer

Solution:

1. Given that Net Income = $946,800

Equity = $7,410,000 and

Dividend payout ratio = 30%

First, we calculate the return on equity

Return on equity, ROE = Net Income/Equity

Return on equity, ROE = $946,800/$7,410,000

Return on equity, ROE = 0.12777 or 12.777%

Growth rate = ROE x (1 - Payout ratio)

Growth rate = 12.777% x (1 -0.30)

Growth rate = 8.94%

Hence, PAMC's growth rate in earnings and dividends should be 8.94%.

2.Retained a higher percentage of earnings will result in a higher growth rate.

Retained a higher percentage of earnings will result in a higher growth rate because retention ratio is directly related to the growth rate.

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