Question

Constant growth rates

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 $16.25.
•	The company’s stock is expected to pay a year-end dividend of $0.78 that is expected to grow at a certain rate.
•	The stock’s expected rate of return is 7.80%.

Based on the information just given, what will be Robert’s forecast of PAMC’s growth rate?

3.00%

2.49%

4.50%

7.75%

Which of the following statements accurately describes the relationship between earnings and dividends when all other factors are held constant?

Long-run earnings growth will decrease when firms retain earnings and reinvest them in the business.

Retaining a higher percentage of earnings will result in a lower growth rate.

All else being equal, growth in dividends requires growth in earnings.

Answer 1

Stock Price = Expected Dividend/(Required return – growth rate)

16.25 = 0.78/(7.80%- growth rate)

Growth rate = 3%

Hence, the forecasted growth rate = 3.00%

Growth rate = Return on Equity*Retention rate

Hence, the correct statement is

All else being equal, growth in dividends requires growth in earnings.

Retaining a higher percentage will lead to a higher growth rate