CFA CFA Level 1 Question of the Week – Equity

Question of the Week – Equity

  • This topic has 2 replies, 2 voices, and was last updated Oct-18 by AdaptPrep.
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  • AdaptPrep
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    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:

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    riteshbadai
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    is the answer 1 

    AdaptPrep
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    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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