Using the P/E ratio approach to valuation, calculate the value of a share of sto

Question

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 12 percent, •the expected level of earnings at the end of this year (Upper E1) is $4, •the firm follows a policy of retaining 30 percent of its earnings, •the return on equity (ROE) is 15 percent, and •similar shares of stock sell at multiples of 9.333 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 $37.33. b. The stock price using the dividend discount model is $. (Round to the nearest cent.)

Explanation / Answer

Using dividend discount model, Stock Price today P0 = D1 / (r - g)

Here, D1 - Dividend next year = E1 x (1 - retention ratio) = 4 x (1 - 30%) = $2.8, r - required rate = 12% and g - growth rate = ROE x retention ratio = 15% x 30% = 4.5%

=> P0 = 2.8 / (12% - 4.5%) = $37.33

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