Question

Assume that you have the following information:- Real rate of interest = 2.0%; Expected Inflation = 3.0%; Required return on the Market = 12.0%; EPS = $2.0; Dividend pay-out ratio = 30.0%; Growth rate in EPS & Dividends per share = 5.0% (constant); Industry P/E multiple is 12; . Answer the following questions:- 1 - The Required or Expected return on the stock is??? 2 - Next year's dividends per share (D1) is ???? 3 - According to the "Constant Growth" model; the current stock price is ??? 4 - According to the P/E multiple, the stock price is ???, note beta=1.5

Answer 1

Given about a company,

Beta = 1.5

EPS = $2.0

Dividend pay-out ratio = 30.0%

Growth rate in EPS & Dividends per share g = 5.0% (constant)

Industry P/E multiple is 12

Real rate of interest = 2.0%; Expected Inflation = 3.0%; Required return on the Market Rm = 12.0%

Risk free rate Rf = real rate + inflation = 2 + 3 = 5%

So, Based on CAPM model expected return on stock is

E(r) = Rf + beta*(Rm - Rf) = 5 + 1.5*(12-5) = 15.50%

next year dividend D1 = EPS*payout ratio*(1+g) = 2*0.3*(1.05) = $0.63

using constant dividend model, current stock price is

P0 = D1/(E(r) - g) = 0.63/(0.155 - 0.05) = $6.00

Based on PE multiple, current years price = (P/E)*EPS = 12*2 = $24