Question

INV Design Ltd. just paid a dividend of $4 and its current earnings per share is $6. The current T-bill rate is 3.5 percent and INV's risk premium is 10 percent. The net profit margin, asset turnover, and debt-to-equity (D/E) ratios are 15 percent, 1.25, and 0.6, respectively. Calculate the current share price by using the P/E ratio approach.

Answer 1

ROE using the dupoint analysis = Net profit margin * Asset turnover * Equity multiplier

Equity multiplier = 1 + Debt to equity ratio = 1+0.6 = 1.6

ROE = 0.15 * 1.25 * 1.6 = 0.1125 or 11.25%

Payout Ratio = Dividend per share / Earnings per share = 4/6 = 66.67%

Growth rate for the firm = (1 - Payout Ratio) * ROE = (1 - 0.67) * 11.25% = 3.75%

EPS1 for the next 12 months = EPS0 (1 + growth rate) = 6 * (1 + 3.75%) = 6.225

Required return on equity = Risk free rate + Risk premium = 3.5% + 10% = 13.5%

Price earnings ratio = Dividend payout ratio/Required rate of return - growth rate = 66.67%/(13.5% - 3.75%) = 6.84

Current share price = EPS 1 * PE ratio = 6.225 * 6.84 = 42.58