Price-Earnings Ratios A firm has positive ROE but zero growth in earnings. The stock is priced...

Question

Question

Price-Earnings Ratios A firm has positive ROE but zero growth in earnings. The stock is priced at $32.40 and has earnings of

Answer 1

Answer #1

As per the earnings retention model or Gordon's growth model :-

The higher the level of retention in a business, the higher the potential growth rate

The formula for calculating Growth is :-

g = br

where,

g = Growth Rate

b = Earnings Retention Rate

r = Return on Equity (ROE)

The problem states that the firm has positive ROE but zero growth in earnings, which clearly implies that Retention Rate (b) is zero

Hence, to achieve growth in earnings, Retention Rate should be >0 and optimal retention ratio is 1

Required return is computed using Earnings Yield formula, i.e by dividing Earnings to the Stock Price

Hence, required return = (3 / 32.4) = 9.26%

Hence, correct answer is Option D :- 9.26% ; 1

Answer 2

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