Question

1. Dividends come out of a company’s net income. Dividends are reported on a per share basis. Earnings Per Share (EPS) is a company’s net income per share of stock. The payout ratio is the percentage of earnings that a company pays out as dividends. So, to calculate payout ratio, you dividend by the EPS. a. If a company pays a dividend of $1.2 and its EPS is $3, what is the payout ratio? A company will often try to maintain a consistent payout ratio. This means that the payout ratio next period is likely to be the same as this period’s payout ratio. b. If expected earnings next period are $3.4. What do you expect next period’s dividend to be? c. Assume that stock price next period is expected to be $40. This means that if you buy the stock, you would collect the dividend you calculated in part b and you could sell it for $40 in one year. Assume that you do sell it in one year. If the required return is 11%, what is the fair value of the stock? (Remember that the value of anything is equal to the present value of its future cash flows.)

Answer 1

Answer a.

EPS0 = $3.00
Dividend, D0 = $1.20

Payout Ratio = Dividend / EPS
Payout Ratio = $1.20 / $3.00
Payout Ratio = 40%

Answer b.

Expected EPS, EPS1 = $3.40

Expected Dividend, D1 = EPS1 * Payout Ratio
Expected Dividend, D1 = $3.40 * 40%
Expected Dividend, D1 = $1.36

Answer c.

Price next year, P1 = $40
Expected Dividend, D1 = $1.36
Required Return, r = 11%

Current Price = D1/(1+r) + P1/(1+r)
Current Price = $1.36/1.11 + $40/1.11
Current Price = $37.26

So, fair value of the stock is $37.26