You forecast a company to have a ROE of 15%, a dividend payout ratio of 30%. The
ID: 2764914 • Letter: Y
Question
You forecast a company to have a ROE of 15%, a dividend payout ratio of 30%. The company has a beta of 1.2. The market risk premium is 8% and the risk free rate is 2%. What is company’s intrinsic forward PE ratio based on the formula? If you also know currently the company has a price of $30, and you forecast the company to have a $1 earnings per share. If firms with similar risks in the industry have a PE ratio of 27 with an estimated earnings growth rate of 12%, is the company overvalued or undervalued based on PEG approach?
Explanation / Answer
Answer
Answer 1
You forecast a company to have a ROE of 15%, a dividend payout ratio of 30%. The company has a beta of 1.2. The market risk premium is 8% and the risk free rate is 2%. What is company’s intrinsic forward PE ratio based on the formula? If you also know currently the company has a price of $30, and you forecast the company to have a $1 earnings per share.
Growth rate = Retention ratio * return on equity
= (1-0.3) * 0.15
= 0.7*0.15
= 0.105
=10.5 %
Dividend for next year = Earnings per share for next year * dividend payout ratio
= $ 1 * 0.3
= 0.3
Cost of equity = Risk free rate + Beta (Market risk premium)
= 2% + 1.2 ( 8%)
= 2% + 9.6%
= 11.6%
Intrinsic value = Dividend for next year / Cost of equity – Growth rate
= 0.3 / 0.116 – 0.105
= 0.3 / 0.011
= $ 27.27
Company’s intrinsic forward PE ratio = Intrinsic value / Earning per share
= $ 27.27 / $ 1
Company’s intrinsic forward PE ratio = 27.27 times
Answer 2
If firms with similar risks in the industry have a PE ratio of 27 with an estimated earnings growth rate of 12%, is the company overvalued or undervalued based on PEG approach?
The price/earnings to growth ratio (PEG ratio) is a stock's price-to-earnings ratio divided by the growth rate of its earnings for a specified time period. The lower the PEG ratio, the more the stock may be undervalued given its earnings performance.
PEG ratio of company = Actual PE ratio of firm / Growth rate of firm
= 30 / 10.5
= 2.857 times
PEG ratio of Industry = Actual PE ratio of industry / Growth rate of industry
= 27 / 12
= 2.25 times
Answer : Here PEG ratio of company is more than industry average, So Company is overvalued based on PEG approach.
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