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Question of the Week - Equity
You are provided the following information about a
company Shoes4You:
Current stock price: $35
- Shares outstanding:
1,000,000
- Past year earnings:
$4,000,000
- Net book value:
$28,000,000
- Past year free cash flow:
$8,000,000
- Dividend payout ratio: 20%
- Cost of equity capital:
11%
- Expected dividend growth
rate: 3%
The justified forward P/E ratio for Shoes4You is closest to:
Question of the Week - Equity 12 votes
0 ·
Comments
Based on the information we are provided, we can use the Gordon growth model (which is the same model used in the text for this problem):
P0 = D1 / (r – g)
The justified P/E ratio based on this model is:
P0 / E1 = (D1 / E1) / (r – g) = p / (r – g)
where
p is the dividend payout ratio (20%)
r is the cost of equity capital (11%)
g is the expected dividend growth rate (3%)
We then have:
P0 / E1 = 0.2 / (0.11 – 0.03) = 2.5
The P/E ratio is Price/Earnings Per Share. The stock price is $35. Earnings per share are $4,000,000 / 1,000,000 = $4. The P/E ratio then is $35/$4 = $8.75.