Question

5-BIG TECH Inc. sells at $40 per share, and its latest 12-month earnings were $8 per share, of which $3.20 per share were paid as dividends.

a. What is Big Tech’s current P/E ratio?

b. If Big Tech’s earnings are expected to grow by 9 percent per year, what is the projected price for next year assuming that the P/E ratio remains constant?

c If you had a required rate of return of 15 percent, expected the dividend payout ratio to remain constant, and dividends to grow at a rate of 9 percent, would you buy this stock? Explain your answer.

Answer 1

A) price of stock is given by = Earnings per share * P/E ratio

Given, price = 40

Earnings per share =8

Hence 40=8* p/e ratio

P/e ratio =40/8

=5

B) Earnings for next year = Earnings for current year *(1+ growth rate)

=8*(1+9%)

=8.72

Given p/e will remain same

Hence price for next year = next year Earnings * p/e ratio=8.72*5= 43.6

C) current dividend payout ratio =current dividend / Earning per share =3.2/8=40%

(Since the payout ratio will remain same dividend of the current year shall be used for deriving price through dividend growth model)

For a dividend growth model, price of stock is given as

=dividend for next year /(required rate of return - growth rate)

Dividend for next year = dividend for current year *(1+ growth rate)

Hence price =

=3.2*(1+9%)/(15%-9%)

=3.488/6%

=58.133

Since the expected price of the stock as per dividend growth model is 58.133 and the stock is currently trading at 40 hence the stock is underpriced and should be purchased.

Hence you should buy the stock of big tech inc.