CFA Practice Question

There are 191 practice questions for this study session.

CFA Practice Question

An analyst gathered the following information about a company:

Current annual earnings per share (E0) reported: $6.00
Current annual dividend per share (D0) paid on the company's common stock: $2.40
Required rate of return on the company's common stock: 15.0%
Expected constant growth rate in earnings and dividends: 8.0%

If markets are in equilibrium, which of the following statements best describes the company's price-to- earnings (P/E) ratio? The company's P/E ratio based on the infinite-period dividend discount model (DDM) is ______
A. less than the company's trailing P/E ratio.
B. the same as the company's trailing P/E ratio.
C. greater than the company's trailing P/E ratio.
Explanation: The trailing P/E ratio is computed as the current stock price divided by the current or trailing 12-months' EPS. On the other hand, the P/E ratio based on the infinite-period dividend discount model is computed as (D/E) / (k - g).

If markets are in equilibrium, the price per share reflects the value determined by the constant growth dividend. Using the constant growth model, the stock's value is ($2.40)(1.08) / 0.07 = $37.03;

the trailing P/E = 37.03 / 6 = 6.17. The DDM P/E is the dividend payout ratio divided by k-g = 0.4 / 0.07 = 5.71. Another way of computing DDM P/E is: Current Market Price / Expected 12-month earnings: 37.03/(6.00 x 1.08) = 5.71.

User Contributed Comments 3

User Comment
nmech1984 How the DDM P/E is calculated? I did not understand either way... Any help guys?
milica818 the DDM P/E is simply stock price = DPR/k-g (a good way to figure out stock price if you're not given current dividend but instead given some variation of the retention ratio or dividend payout ratio.
milica818 however, why do they divide $37.03 by 6? confused
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