- This topic has 7 replies, 4 voices, and was last updated Dec-1711:42 am by
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Up6
And what’s the point of calculating the 2.5 if all you had to do was divide the price by EPS for the answer?
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Up5
Wait…i’m a bit confused. Why wouldn’t the answer be the second choice (3)? I thought the formula for the justified P/E was dividend payout ratio/r-g. I wasn’t aware you were actually supposed to calculate the P/E using current price/ EPS for the justified P/E.
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Up3
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. -
Up3
Yea I am not following the solution either
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Up2
@PassedTense‌ can you elaborate? Clarification would be great 🙂
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Up2
I apologize for the confusion. I marked 9 as the final answer when it should have been 3.
The justified forward P/E ratio is the P/E ratio calculated using forecasted earnings, i.e. P0 / E1 in this case. We make use of the dividend discount model for valuing the price of a stock.
The last paragraph of the solution calculates what the regular P/E ratio would have been. It’s not what the question is asking for.
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Up2
thanks for the clarification!
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