- CFA Exams
- CFA Level I Exam
- Study Session 10. Equity Valuation (2)
- Reading 27. Discounted Dividend Valuation
- Subject 5. Gordon growth model and the P/E ratio

###
**CFA Practice Question**

ABC shares are currently trading at $17.50 per share. The company is widely expected to retain 72% of their next year's earnings, resulting in a dividend payment of $1.25. Further research reveals that ABC has a beta of 1.3, at a time when the market risk premium is 5.2% above the risk-free rate of 3.2%. What should be leading P/E ratio for ABC if its earnings are expected to grow at 6% indefinitely?

B. 7.07.

C. 12.84.

A. 3.92.

B. 7.07.

C. 12.84.

Correct Answer: B

P

Step 1. Compute the cost of equity. R

_{ABC}= R_{F}+ β_{ABC}[R_{M}- R_{F}] = 3.2% + 1.3 x 5.2 = 9.96%Step 2. Set up Gordon growth model: P

_{0}= D_{1}/(R - G)Step 3. Divide both sides by earnings expected one period hence.

P

_{0}/E_{1}= (D_{1}/E_{1})/(R - G) = (1 - 0.72)/(0.0996 - 0.06) = 7.07.Note that the payout ratio is simply equal to: (1 - retention rate).

###
**User Contributed Comments**
3

User |
Comment |
---|---|

Nightsurfer |
Why can't you figure out expected earnings from the expected dividend payment of $1.25 and divide it into the current stock price? E1 = 1.25 / (1 - 0.72) = $4.4643 P0/E1 = $17.50 / $4.4643 = 3.95 |

noonah |
Nightsurfer, you have calculated the actual leading P/E, not the one as per GGM, as the question indicates by "what should be the leading P/E". Fundamental to GGM is the discounting by the factor (r-g). |

davidt876 |
nice noonah. and because the actual P/E is lower than the estimated P/E with GGM, we can assume that the stock price has room to grow |