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**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%

P

_{0}= (4.45 x 0.5) / (0.105 - 0.050) = 40.45

P/E ratio = 40.45 / 3.50 = 11.56

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**User Contributed Comments**
17

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%.... Two adjustments to consider EPS1 = 4.45-.95 = 3.50 (new) I am kinda fascinated we used EPS as dividend payout per share |

gyee2012 |
... nvm i was confused now understand... |