### CFA Practice Question

Meritronic Labs' trailing twelve months (TTM) earnings per share work out to 4.45. After adjusting them for non-recurring items, they are reduced by 0.95. Meritronic is a constant growth stock with a growth rate of 5%, and its next year's dividend will be about 50% of its unadjusted TTM. Meritronic has an average market beta with market risk premium of 4.75%. The economy's expected real growth rate is projected at 3.25% with an inflation rate of 2.5%. What is the correct P/E ratio for Meritronic?
A. 7.15
B. 9.09
C. 11.56
Explanation: Adjusted EPS (for non-recurring items) = 4.45 - 0.95 = 3.50
Discount rate = real rate + inflation premium + market risk premium = 3.25 + 2.50 + 4.75 = 10.50%
P0 = (4.45 x 0.5) / (0.105 - 0.050) = 40.45
P/E ratio = 40.45 / 3.50 = 11.56

User Comment
anricus Why is the discount rate used not the nominal + the market risk premium.

Would it be incorrect to calculate discount rate as ((1+r)*(1+i)) + Mrp
eddeb Another way :

Next year's payout ratio = ( 0.5*4.45) / 3.5 = 64.42*

P/E = 0.64 / (10.5% - 5%) = 11.558
jayjunk In this question it is being assumed that the riskfree rate is = economy's expected real growth rate + expected inflation rate.

I am not sure that this is true.
mirco Shouldn't we use E1 instead of E0? Thus, next years expected earning = 3.5*1.05 = 3.675 and P/E1 ratio becomes 11.01
patsy we are told what next years earnings are - UNadjusted TTM times 50%.
rgat it clearly says that "next year's dividend will be about 50% of its unadjusted TTM" meaning D1 = (.5)(4.45-0.95)=1.75

This Question = Wrong
vikram59 unadjusted is 4.45 and adjusted is 3.5. The question is correct
JepTang Would anybody agree that the answer should have been B and not C? In the question it says that this is a constant growth stock therefore the valuation method should have used this formula:
Po= [D*(1+g)]/(k-g)
Thus the value of the stock should have been 42.48.
The earnings would also grow by 5% therefore 4.45*1.05 would give you 4.6725

P/E= 42.48/4.6725 = 9.0915
Anybody?
NickPash for JEPTang, Yes I got "B" due to constant growth comment but hindsight is 20/20, they are replacing Div1=div0*(1+g) with Div1= unadjusted EPS*50%. So it is tricky. so, we have to read everything carefully.
mekc totally didn't see the "next years div will be unadjusted TTM X 50%" tricky tricky tricky!
Magoo This question is like saying next year's dividend is based on the temperature or a player's jersey number. If you set the dividend based on non-recurring items in earnings, how can you use the dividend discount model to determine p0? What confidence do you have in dividends beyond d1?
thebkr7 @eddeb. Thanks!
mpeterson @rgat thank you for your comment, I'll forward this discrepancy to analyst notes.
Lambo83 I answered C but now realize B is actually correct (so I got lucky).

The Forward Price Earnings ratio is P/E1. The adjusted EPS of 3.5 needs to be increased by the growth rate of 5%.

D1/E1 / (r - g)

0.5 x (3.5 x 1.05) / (0.105 - 0.05) = 33.41

P/E1 = 33.41 / (3.5 x 1.05) = 9.09
cfa_test_2 Is there a reason why it is "0.5" rather than "(1+0.5)" that is used in the formula for Po?
gyee2012 Read the question next year is 50% so we the new d1 should be 4.45(.50) rather than 4.45(1.05) which the problem puts out 5%....