Question

xyz stock has an expected ROE of 10% per year, expected earnings per share of $5 and expected dividend is $2 per share. Its market capitalization rate is 12% per year.

A) what are the firms price and price earnings ratio?

b) If the firm increases its plowback ratio to 0.8, what would be its price and price- earnings ration?

c) compare the results of A and B to explain the effect of the plowback ratio on the price- earnings ratio.

Answer 1

Part A:

Price P= E1(1-b)/(r-ROE*b)

Where E1= Expected EPS (given as $5), r= Rate of return (given as 12%), ROE= Return on Equity (given as 10%) and b= plowback ratio

Also given, Expected Dividend (D1) = $2.

Therefore, plowback ratio (b) = (E1-D1)/E1 = ($5-$2)/$5= 60%

Plugging the values,

Price P= 5*(1-0.6)/(0.12-0.1*0.6) = $33.33

Price Earnings Ratio (PE) = P/E1= 33.33/5 = 6.67 times

Part B:

If plowback (b) is increased to 80%:

Price= 5*(1-0.8)/(0.12-0.1*0.8) = $25

PE Ratio= 25/5 = 5 times.

Part (C ):

When plowback ratio is increased, dividend payout is decreased and price also is decreased. As a result, Price Earnings Ratio also comes down.