Question

P10-12 (similar to) Question Help (Related to Checkpoint 10.2) (Relative valuation of common stock) 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 (E) is $8, • the firm follows a policy of retaining 40 percent of its earnings, • the return on equity (ROE) is 12 percent, and • similar shares of stock sell at multiples of 8 334 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 $ 66.67. (Round to the nearest cent) b. The stock price using the dividend discount model is $ (Round to the nearest cent.) Enter your answer in the answer box and then click Check Answer. All parts showing Clear All Check Answer

Answer 1

Share price using PE method
Expected earnings	$           8.00
PE ratio	8.334
Share price=	Expected earning * PE ratio
Share price=	8*8.334
Share price=	$        66.67
Share price using the dividend discount model
Share price=	Next dividend/(Cost of equity -growth rate)
So we need to calculate the next dividend and growth rate
Calculation of the next dividend
Expected earnings	$           8.00
Retention ratio	40%
Dividend payout ratio	1-40%	60.0%
Next dividend=	Expected earning * dividend payout ratio
Next dividend=	8*60%
Next dividend=	$           4.80
Calculation of growth rate
Return on equity	12%
Retention ratio	40%
Growth rate	Return * Retention
Growth rate	12%*40%	4.800%
Calculation of share price
Share price=	Next dividend/(Cost of equity -growth rate)
Share price=	4.8/(12%-4.80%)
Share price=	$        66.67