Question

# Suppose that a firm’s recent earnings per share and dividend per share are \$2.70 and \$1.70,...

Suppose that a firm’s recent earnings per share and dividend per share are \$2.70 and \$1.70, respectively. Both are expected to grow at 9 percent. However, the firm’s current P/E ratio of 18 seems high for this growth rate. The P/E ratio is expected to fall to 14 within five years. Compute the dividends over the next five years. Compute the value of this stock price in five years Calculate the present value of these cash flows using an 11 percent discount rate

Recent Dividend, D0 = \$1.70

Growth rate, g = 9%

D1 = \$1.7000 * 1.09 = \$1.8530
D2 = \$1.8530 * 1.09 = \$2.0198
D3 = \$2.0198 * 1.09 = \$2.2015
D4 = \$2.2015 * 1.09 = \$2.3997
D5 = \$2.3997 * 1.09 = \$2.6157

Current EPS, EPS0 = \$2.70

Growth rate, g = 9%

EPS5 = EPS0 * (1 + g)^5
EPS5 = \$2.7000 * 1.09^5
EPS5 = \$4.1543

P/E Ratio = 14

P/E Ratio = P5 / EPS5
14 = P5 / \$4.1543
P5 = \$58.1602

Discount Rate = 11%

P0 = \$1.8530/1.11 + \$2.0198/1.11^2 + \$2.2015/1.11^3 + \$2.3997/1.11^4 + \$2.6157/1.11^5 + \$58.1602/1.15^5
P0 = \$36.97

So, present value of these cash flow is \$36.97