Question

7. Constant growth rates

One of the most important components of stock valuation is a firm’s estimated growth rate. Financial statements provide the information needed to estimate the growth rate.

Consider this case:

Robert Gillman, an equity research analyst at Gillman Advisors, believes in efficient markets. He has been following the mining industry for the past 10 years and needs to determine the constant growth rate that he should use while valuing Pan Asia Mining Co.

Robert has the following information available:

•	Pan Asia Mining Co.’s stock (Ticker: PAMC) is trading at $21.25.
•	The company has forecasted net income and book value of equity for the coming year to be $1,341,300 and $10,497,500, respectively.
•	The company has also been paying dividends for the past eight years and has maintained a dividend payout ratio of 42.500000%.

Based on this information, Robert’s forecast of PAMC’s growth rate in earnings and dividends should be:

8.15%

28.75%

7.35%

27.16%

Which of the following statements accurately describes the relationship between earnings and dividends when all other factors are held constant?

Growth in earnings requires growth in dividends.

Retaining a higher percentage of earnings will result in a higher growth rate.

Long-run earnings growth occurs primarily because firms pay dividends to reward their shareholders for investing in the company.

Answer 1

Robert's forecast of PAMC's growth rate in earnings and dividends

Return n Equity (ROE) = [Net Income / Total Equity] x 100

= [$1,341,300 / $10,497,500] x 100

= $12.78%

Therefore, the growth rate in earnings and dividends = Return on Equity x Retention ratio

= Return on Equity x (1 – Dividend payout ratio)

= 12.78% x (1 – 0.4250)

= 12.78% x 0.5750

= 7.35%

Therefore, the Robert's forecast of PAMC's growth rate in earnings and dividends will be 7.35%”

The correct statements which describes the relationship between earnings and dividends when all other factors are held constant is as follows;

Option-III, The Long-run earnings growth occurs primarily because firms pay dividends to reward their shareholders for investing in the company.