Question

The market capitalization rate on the stock of Aberdeen Wholesale Company is 8%. Its expected ROE is 10%, and its expected EPS is $3. If the firm's plowback ratio is 65%, its P/E ratio will be _________.

26.78

17.28

23.33

66.67

Answer 1

Information provided:

Market capitalization rate= 8%

Return on equity= 10%

Expected EPS= $3

Plowback ratio= 65%

Dividend payout ratio= 1 - Plowback ratio

                                          = 1- 0.65

                                          = 0.35

Expected dividend= Dividend payout ratio* Expected EPS

                                 = 0.35*$3

                                 = $1.05

Next, the sustainable growth rate is calculated using the below formula:

Sustainable growth rate= ROE* Plowback ratio

                                              = 10%*0.65

                                              = 6.50%.

The price of the stock is calculated using the dividend discount model.

Current stock price= Expected dividend/ (Market capitalization rate – growth rate)

                                     = $1.05/ 0.08 – 0.065

                                     = $1.05/ 0.0150

                                     = $70

Price to Earnings ratio is calculated using the following formula:

Price to Earnings (P/E)= Stock price per share/Earnings per share

                                             = $70/ $3

                                             = 23.33 times.

Hence, the answer is option c.

In case of any query, kindly comment on the solution.