To determine justified PE ratio you have run a regression of PE ratio against di

Question

To determine justified PE ratio you have run a regression of PE ratio against divdend payout ratio, equity beta, and expected earning growth rate across a group a similar companies anhd arrived the following results: PE=4+10*(Dividend payout ratio)-10*(Beta)+80*(Expected growth rate in EPS) (Thus, if your dividend payout ratio is 50%, beta is 2 and expected growth rate is 20%, your justified PE=4+10*0.5-10*2+80*0.2=5). Assume that you are looking at a company that is trading at a PE ratio of 16, and has dividend payout ratio of 75%, beta of 0.75 and expected growth rate of 20%. With the regression, what will be justified PE ratio and should you buy the company's stock or not? calculate the justified PE ratio should you buy the company the stock or not?

Explanation / Answer

Justified P/E = 4 + 10 * Dividend Payout - 10* Beta + 80* Expected Growth rate in EPS Dividend Payout = 75% Beta = 0.75 Expected Growth Rate = 20% Justified P/E = 4 + 10*.75 - 0 * 0.75 + 80*.2 = 4 + 7.5 - 7.5 +16 = 20 Current P/E Ratio = 16 P/E ratio= MPS/EPS This means that stock is currently undervalued and is a good investment opportunity. Hence, one should accumulate the stock till P/E levels of 20

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