Question

Deakin Ltd has just recently published following financial information:

Expected earnings per share $20

Deakin’s market beta 0.8

Earnings per share to be retained by the firm 30%

Growth rate in earnings per share 7% p.a.

Required: 1. Calculate Deakin's P/E ratio if the expected return on the ASX300 is 12% p.a. and the return on 10 year Commonwealth Government Bonds is 4% p.a. What does this ratio tell you?

2. Calculate Deakin's share price using P/E ratio calculated in Part 1.

Answer 1

Answer : Calculation of Price Earning Ratio :

price Earning Ratio = Price / Earning per share

Price = Expected Dividend / (Cost of equity - Growth rate)

Expected Dividend = Expected Earning * (1 - Retention ratio)

= 20 * (1 - 0.30)

= 14

Cost of Equity = Risk Free rate + Beta * (Return from Market - Risk Free rate)

= 4% + 0.8 * (12% - 4%)

= 4% + 6.4%

= 10.4%

Price = Expected Dividend / (Cost of equity - Growth rate)

= 14 / (0.104 - 0.07)

= 411.76

Price Earning Ratio = 411.76 / 20

= 20.59

This Ratio shows that by investing $20.59 dollar the investor would receive earning of $1.

2.) Calculation of Share Price using PE ratio

Price = PE ratio * Earning

= 20.59 * 20

= 411.76