Question

Question #4: Stock Valuation and P/E Ratio [16 Points) The research analyst at Needham & Company believes that Tootsie Roll Industries has a return on equity (ROE) of 11% with a beta (B) of 0.60. Tootsie Roll Industries plans to maintain indefinitely its plowback ratio of 0.58. The firm's earnings this year (E.) were equal to $1.20 per share. The research analyst estimates that the expected return this year for the market E(r.) will equal 12.5% and T-bills will offer a 2.5% return (ry = 0.025). (a) Find the price at which a share of Tootise Roll Industries should sell. [ Points) (b) Calculate the P/E ratio for Tootsie Roll Industries. [3 Points) (c) Suppose the research analyst publishes a report stating that they believe that Tootsie roll will soon raise its plowback ratio to 0.62. If you're a current stockholder in Tootsie Roll should you purchase more stock or sell your position? Assume that the stock is currently trading at the value you found in Part (a). Explain your reasoning. [Hint: Earnings next year will change.) (8 Points)

Answer 1

(a) Using gordon growth model: P=D(1+g)/(ke-g)

ke=rf+beta*(rm-rf)=0.085

g= RR*ROE..RR=Plowback ratio

g=0.064

D=0.504=(1-RR)*EPS

So, P=25.290 based on P=D*(1+g)/(ke-g)

(b)=P/E=Price per share/EPS=25.290/1.2=21.075

(c) Using the methodology in a we find that if the plowback ratio changes to 0.62, then the price per share comes out to be 28.994. If the current market price is 25.290, then the stock is undervalued and you should purchase more stock.

(a)-explaination=ke=cost of equity

RR= plowback ratio

rf=t-bills return

rm=expected matrket return

g=growth rate

ROE=Return on equity

In this question we should use the gordon growth model to estimate all of these key indicators using the formula mentioned in part a and we would be able to derive the current market price based on growth rate, dividend, and cost of equity.