Question

Company FFF’s most recent EPS IS $5.00 per share. Your expect the company will increase EPS by 10% next year and 8% the following year. You also expect that Company FFF will sell at a P/E multiple (tm) of 24 in 2 years. The company is expected to pay out 20% of earnings as a dividends and the required rate of retueb for FFF is 9%?

a) What is your estimate for Earnings per Share over thr next two years?

b) Using a P/E multiple approach what is your estimate of the stock price in 2 years?

c) Using a P/E multiple approach what is your estimate of the stock price in 2 years?

d) What is the implied long run constant growth rate you are assuming when you expected the stock to sell for a ttm P/E multiple of 24 at the end of year 2?

show calculation

Answer 1

a]

EPS after 1 year = current EPS + 10% = $5.00 + 10% ==> $5.50

EPS after 2 years = EPS after 1 year + 8% = $5.50 + 8% ==> $5.94

b] and c]

Estimated stock price in 2 years = Estimated EPS after 2 years * estimated PE multiple after 2 years

Estimated stock price in 2 years = $5.94 * 24 ==> $142.56

d]

required rate of return on equity = (next year dividend / current share price) + constant growth rate

As the EPS growth for year 3 is not given, let us assume it is 8% (same as year 2)

Dividend in year 3 = (EPS of year 2 + 8%) * payout ratio

Dividend in year 3 = ($5.94 + 8%) * 20% ==> $1.28

required rate of return on equity = (next year dividend / current share price) + constant growth rate

0.09 = ($1.28 / $142.56) + constant growth rate

constant growth rate = 0.081, or 8.1%