Question

Consider two companies, named A and B, that are identical in every respect except that A will grow at 5% and B at 3%. Investors require a12% return for both companies, next year EPS are expected to be $1.00 for both companies and the dividend payout rate is 30%.

Part 1: What is the fair price of stock A?

Part 2: What is the price of stock A if you use P/E ratio of stock B to determine the price of stock A?

Answer 1

As per Gordon model,
Price = Dividend in next year/(r-g)
			A	B
		EPS next year	1	1
		Dividend payout	30%	30%
		Dividend next year	0.30	0.30
		Growth rate, g	5%	3%
		Rate of return	12%	12%
		P =	0.3/(0.12-0.05)	0.3/(0.12-0.03)
	1)	Price, P =	4.29	3.33
	2)	P/E = Price/EPS	4.29	3.33
		IF P/E of stock B is used then P/E of stock B = 3.33
		Price A = EPS * P/E of stock B
		Price A = 1 * 3.33	3.33