7. Constant-growth rates Aa Aa One of the most important components of stock val

Question

7. Constant-growth rates Aa Aa 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. Robert has the following information available Pan Asia Mining Co.'s stock (Ticker: PAMC) is trading at $13.75 The company has forecasted net income and book value of equity for the coming year to be $867,900 and $6,792,500, respectively. The company has also been paying dividends for the past 8 years and has maintained a dividend payout ratio of 27.50%. Based on this information, Robert's forecast of PAMC's growth rate in earnings and dividends should be: O 9.59% O 17.57% O 9.26% O 5.27% Which of the following statements accurately describes the relationship between earnings and dividends when all other factors are held constant? O Growth in earnings requires growth in dividends. O Retaining a higher percentage of earnings will result in a higher growth rate. O Long-run earnings growth occurs primarily because firms pay dividends to reward their shareholders for investing in the company.

Explanation / Answer

Growth rate = ROE x (1 - payout ratio)

ROE = Net Income / Equity = 867,900 / 6,792,500 = 12.78%

Growth rate = 12.78% x (1 - 27.50%) = 9.26%....a)

As can be seen in the equation above, reduction in payout ratio, i.e., increase in retaining higher percentage of earnings, will result in higher growth rate. Hence, the second statement is correct.

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