CFA CFA Level 1 Question of the Week – Equity

Question of the Week – Equity

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      8

      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:
      • 1
      • 3
      • 9
    • Up
      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?

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      4

      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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      3

      Yea I am not following the solution either

    • Up
      2

      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 / (rg)

       

      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.

    • Up
      2

      @PassedTense‌ can you elaborate? Clarification would be great 🙂

    • Up
      2

      thanks for the clarification! 

    • Up
      1

      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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