CFA CFA Level 1 Question of the Week – Equity

# Question of the Week – Equity

• Author
Posts
Participant
• Undecided
10

You are provided the following information about a company Shoes4You:

â€¢ Current stock price: \$35
â€¢ Shares outstanding: 1,000,000
â€¢ Past year earnings: \$4,000,000
â€¢ Net book value: \$28,000,000
â€¢ Past year free cash flow: \$8,000,000
â€¢ Dividend payout ratio: 20%
â€¢ Cost of equity capital: 11%
â€¢ Expected dividend growth rate: 3%
The justified forward P/E ratio for Shoes4You is closest to:
• 1
• 3
• 9
• simply_complex2
Participant
• CFA Level 1
6

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?

• simply_complex2
Participant
• CFA Level 1
5

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.

Participant
• Undecided
3

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 â€“ g)

The justified P/E ratio based on this model is:

P0 / E1 = (D1 / E1) / (r â€“ g) = p / (r â€“ 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 â€“ 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.

• 3

Yea I am not following the solution either

• policedog
Participant
• Undecided
2

@PassedTenseâ€Œ can you elaborate? Clarification would be great ðŸ™‚

Participant
• Undecided
2

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.

• simply_complex2
Participant
• CFA Level 1
2

thanks for the clarification!