5.29 Consider Pacific Energy Company and U.S. Bluechips, Inc., both of which reported earnings of $1.1 million. Without...

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5.29 Consider Pacific Energy Company and U.S. Bluechips, Inc., both of which reported earnings of $1.1 million. Without new p

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Answer 1

Answer #1

Valuation as per DDM model : it assumes that current market price of stock is Present Value of all Dividend payouts in future.

1. Pacific Energy

Reported earnings is $ 1.10 million ( continue to generate in future too)

Company has 100% payout ratio that means it is distributing all $1.10 Million as dividend.

Current Equity Value of Company = $1.10 ÷ 12% = $9.167 Million ( using formula for present value of perpetuity )

Current PE = $9.167 Million ÷ $1.10 Million = 8.33 times

Revised Earning (after including additional earnings) = $1.10 million + $0.220 million = $1.32 million

Now to calculate New PE, two views are possible

1. PE based on Current Equity Value of Company.

= $ 9.167 million ÷ $ 1.32 million = 6.94 times

2. PE after calculating New Equity Value

New Equity Value = $1.32 ÷ 12% = $ 11.00 million

New PE = $ 11.00 million ÷ $1.32 million = 8.33 times

if company has any new project, market knows it and price of stock changes accordingly.. So no. 2 is close to reality but for exam point of view no. 1 approch is preferred.

2. U.S. blue chip

Reported earnings = $ 1.10 Million

Payout 100%

Current equity value (using formula of PV of perpetuity) = $ 1.10 million ÷ 12% = $ 9.167 million

Current PE = Value / earnings = $ 9.167 / $ 1.10 = 8.333

Revised Earning = $ 1.10 million + $ 0.44 million = $ 1.54 million

New PE (as per view 1) = $ 9.167 / $1.54 = 5.95 times

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Answer 2

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