CFA Practice Question
The forward P/E ratio of a stock equals 7.1. The company has just released its earnings figures at $12.20 per share. The firm's dividend payout ratio is 28%. If the current stock price is $100, what is its 1-year expected return under the dividend discount model?
A. 19.40%
B. 14.83%
C. neither of these answers
Explanation: It is important to remember that the forward P/E ratio is the ratio of the current stock price and next year's expected earnings. The firm's expected earnings next year equal 100/7.1 = $14.09 per share. Since the current earnings equal $12.2, the dividend growth rate equals (14.09/12.2 - 1) = 15.45%. To get the 1-year expected return, first calculate the expected price next year. Under the dividend discount model, the P/E ratio remains constant if the firm makes no policy changes and there are no market disruptions. Therefore, the price next year is expected to be $100*(1 + 15.45%) = $115.45. The dividend next year equals $14.09 * 0.28 = $3.95 per share. Thus, the 1-year expected return (capital gains + dividends) = (P1+D1)/P0 = (115.45 + 3.95)/100 - 1 = 19.4%.
User Contributed Comments 14
| User | Comment |
|---|---|
| shasha | growth rate "g" is for both dividend growth and price growth. so P1 = P0*(1+g) = 100*1.1545 |
| derekt | If the P/E ratio is the historical P/E one the growth could be estimated from the information given and used to find next years EPS. |
| danlan | E=100/7.1, g=E/12.2-1, The result is (100*(1+g)+E*0.28)/100-1 =g+E*0.28/100=g+0.28/7.1 |
| jerepast | where does this come from? [dividend growth rate = (NI(n+1)/NI(n) - 1)] |
| ontrack | Try this method: Po/E1=(D1/E1)/k-g Po/E1 is 7.1, g=15.45% as per the soultion given, D1/E1 is .28(also given in Qs). Put in values to get k=19.33%=expected discount rate or returns expected . |
| steved333 | 7.1x12.20=86.62 .28x12.20=3.416 100-86.62=13.38 (13.38+3.416)/86.62= .1939 Not hard if you use the STO and RCL buttons on the BAII. |
| steved333 | Just figure out the original price then use the HPY formula of (FV-PV+Div)/PV. |
| surob | looks like it is not that difficult question |
| Hervz | You always have to keep in mind that the dividends are growing at the same pace as the earnings (RR stays th same). - for the purpose of the test, anyway |
| serboc | HERVZ: So your telling me that you can take g (if given) X Eo = E1? |
| mekc | thx ontrack... like that method |
| SaeedAlam | Thanks Steve that really helped it matches with the notes on price multiples! |
| dipu617 | @steved333 Could you please tell us how to use STO and RCL buttons on BA II Plus for this problem? Thank you. |
| santibanez | PER=PayOut/(r-g) Obtain g by estimating E1 first r=(PayOut/PER)+g r=(.28/7.1)+.15447 r=.1938 |