Question

Calcuate Company A P/E ration if expected return is 10% p.a and return on Goverment bonds is 4%.

Expected earnings per share $18

Market beta 0.6

Earnings per share retained by from 40%

Growth rate in earnings per share 0.07

Do we use CAPM forumla to calcuate this ?

Answer 1

P/E ratio = Price per share/Earnings per share

Price per share = expected dividend/(cost of equity - dividend growth rate)

expected dividend = Expected earnings per share*(1-retention rate) = $18*(1-0.40) = $18*0.60 = $10.8

cost of equity = return on Government bonds + beta*(expected market return - return on Government bonds)

cost of equity = 4% + 0.6*(10% - 4%) = 4% + 0.6*6% = 4% + 3.6% = 7.6%

Price per share = $10.8/(0.076 - 0.07) = $10.8/0.006 = $1,800

P/E ratio = $1,800/$18 = 100