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Question of the Week - Equity

AdaptPrepAdaptPrep Des Moines, IA, USAPosts: 211 Sr Associate
edited May 2016 in Level 1 Questions

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

1
0%
3
41%
PahtsanbenmcdnldKpaxxavannoordsuls 5 votes
9
58%
AdaptPrepduyhg99mdlynch3pabulumsSwatiaaronpcjbDMD 7 votes

Comments

  • AdaptPrepAdaptPrep Des Moines, IA, USAPosts: 211 Sr Associate
    9

    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.

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