CFA Practice Question

There are 96 practice questions for this study session.

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?

A. 3.92.
B. 7.07.
C. 12.84.
Correct Answer: B

Step 1. Compute the cost of equity. RABC = RF + βABC[RM - RF] = 3.2% + 1.3 x 5.2 = 9.96%

Step 2. Set up Gordon growth model: P0 = D1/(R - G)

Step 3. Divide both sides by earnings expected one period hence.
P0/E1 = (D1/E1)/(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
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