Question

Company ABC forecasts to have a earning per share of $8 next year. If the company distributes all its earnings to shareholders as dividends, it will provide investors with a 10% expected return. Instead, company ABC decides to plowback 35% of the earnings at the firm’s current return on equity of 20%. What is the value of the stock before and after the plowback decision?

Answer 1

Value of stock before plowback is computed as shown below:

= Dividend per share / expected return

= $ 8 / 0.10

= $ 80

Value of stock after plowback is computed as shown below:

= Dividend per share / (required return - growth rate)

Dividend per share is computed as follows:

= $ 8 x (1 - plowback ratio)

= $ 8 x (1 - 0.35)

= $ 5.2

growth rate is computed as follows:

= plowback ratio x return on equity

= 0.35 x 0.20

= 0.07

So, the value will be as follows:

= $ 5.2 / (0.10 - 0.07)

= $ 173.33 Approximately

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