CFA CFA Level 1 Question of the Week – Equity

Question of the Week – Equity

  • Author
    Posts
    • Avatar of AdaptPrepAdaptPrep
      Participant
        • Undecided
        Up
        10
        ::

        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
      • Avatar of simply_complex2simply_complex2
        Participant
          • CFA Level 1
          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?

        • Avatar of simply_complex2simply_complex2
          Participant
            • CFA Level 1
            Up
            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.

          • Avatar of AdaptPrepAdaptPrep
            Participant
              • Undecided
              Up
              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 / (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
              3
              ::

              Yea I am not following the solution either

            • Avatar of policedogpolicedog
              Participant
                • Undecided
                Up
                2
                ::

                @PassedTense‌ can you elaborate? Clarification would be great 🙂

              • Avatar of AdaptPrepAdaptPrep
                Participant
                  • Undecided
                  Up
                  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.

                • Avatar of simply_complex2simply_complex2
                  Participant
                    • CFA Level 1
                    Up
                    2
                    ::

                    thanks for the clarification! 

                Viewing 7 reply threads
                • You must be logged in to reply to this topic.