Question

The market consensus is that Analog Electronic Corporation has an ROE = 12%, a beta of 1.75, and plans to maintain indefinitely its traditional plowback ratio of 1/4. This year’s earnings were $2.00 per share. The annual dividend was just paid. The consensus estimate of the coming year’s market return is 13%, and T-bills currently offer a 6% return.

a. Find the price at which Analog stock should sell. (Do not round intermediate calculations. Round your answer to 2 decimal places.)

b. Calculate the P/E ratio. (Do not round intermediate calculations. Round your answer to 2 decimal places.)

c. Calculate the present value of growth opportunities. (Negative amount should be indicated by a minus sign. Do not round intermediate calculations. Round your answer to 2 decimal places.)

d. Suppose your research convinces you Analog will announce momentarily that it will immediately change its plowback ratio to 3/4. Find the intrinsic value of the stock. (Do not round intermediate calculations. Round your answer to 2 decimal places.)

Answer 1

a). k = rf + β[Ε(rM) – rf ]

= 6% + 1.75(13% - 6%) = 6% + 12.25% = 18.25%

g = b x ROE = (1/4) × 12% = 3%

D1 = E0(1 + g) x (1 - b) = $2(1.03) x (3/4) = $1.545

P0 = D1/(r - g) = $1.545 / (0.1825 - 0.03) = $10.13

b). Leading P0/E1 = $10.13/($2 x 1.03) = 4.92

Trailing P0/E0 = $10.13/$2.00 = 5.07

c). PVGO = P0 - [E1/k] = $10.13 - [$2.06/0.1825] = $10.13 - $11.29 = -$1.16

The low P/E ratios and negative PVGO are due to a poor ROE (12%) that is less than the market capitalization rate (18.25%)

d). Now, you revise b to 3/4,

g = (3/4) x 12% = 9%, and

D1 =:$2 × 1.09 × (1/4) = $0.545

Thus:

V0 = $0.545/(0.1825 - 0.09) = $0.545/0.0925 = $5.89