Question

IBM has ROE =9% and a beta if 1.25. It plans to maintain indefinitely its traditional plowback ratio. This year’s earnings were $3 per share. The annual dividend was just paid. The consensus estimate of the coming year’s market return is 14% and T-bill currently offers a 6% return. The leading P/E is 3.33 and the stock is sold at $10.60. What is the traditional plowback ratio

Answer 1

Given about IBM,

ROE = 9%

Beta = 1.25

Last year earning E0 = $3

Expected return on market Rm = 14%

Risk free rate Rf = 6%

So, using CAPM, cost of equity Ke of IBM is > Ke = Rf + beta*(Rm - Rf) = 6 + 1.25*(14 - 6) = 16%

current stock price P0 = $10.60

Leading P/E ratio = 3.33

=> Expected EPS next year E1 = P0/(P/E) = 10.60/3.33 = $3.18

So, growth rate in earning = (E1-E0)/E0 = (3.18-3)/3 = 6%

We know that, growth rate = ROE*(1-Plowback ratio)

=> 6 = 9*( 1 -Plowback ratio)

=> Plowback ratio = 33.33%