Question

SUBJECT 3

a. A company with a dividend payout ratio of 40% for 2018, has a ROE of 10%. The dividends and stock’s earnings are expected to grow at the same rate. The current year earnings per share are 7 euros and the company has a beta coefficient of 1. The risk-free rate is 6% and analysts estimate that the market risk premium is 5%. Taking into account the above information, estimate:

I. The expected growth rate, and its P/E ratio.

II. The intrinsic value of Salomon company using the P/E ratio approach.

III. If dividend growth forecasts for Salomon Company are revised downward by 1% what will happen to the Salomon stock price and P/E ratio. IV. Explain how an increase in dividend payout would affect the (all other factors remain constant) growth rate and P/E ratio.

b. Τhe price to earnings ratio indicates the expected price of a share based on its earnings. As a company’s earnings per share rise, so does their market value per share. A company with a high P/E ratio usually indicates positive future performance and investors are willing to pay more for this company’s shares. But reported earnings are computed in accordance with generally accepted accounting rules and often management can easily manipulate it with specific accounting techniques. Which are those accounting methods that artificially may restructure the P/E ratio trend line?

Answer 1

PART-A

Sub Question-1

Growth rate = Return On Equity * ( 1 - Dividend Payout Ratio )

= 10% * ( 1 - 40% )

= 0.1 * ( 1 - 0.4 )

= 0.1 * 0.6

= 0.06 or 6%

Price-Earnings Ratio (P-E Ratio)

Dividend Payout Ratio / ( Required rate of return - Dividend growth rate)

Here, Required rate of return is not given. Hence we have to find it using Capital Asset Pricing Model.

The formula to calculate Required rate of return using Capital Asset Pricing Model is as follows:-

Required rate of return = Risk free rate +( Beta * Market Risk Premium )

= 6% + ( 1 * 5%)

= 11%

Therefore,

P-E Ratio = 40% / ( 11% - 6%)

= 40% / 5%

= 8%

Note :-

Here since details to calculate proper PE-Ratio is not provided. Hence Justified PE-Ratio is calculated.

Sub Question- 2

Intrinsic Value = PE-Ratio / Growth rate

= 8% / 6%

= 0.08/ 0.06

= 1.33 euros per share

Sub Question-4

An increase in dividend payout will automatically affect the growth rate and PE-Ratio as to calculate both , Dividend payout is necessary.

Growth rate = Return On equity * ( 1- dividend payout)

So, an increase in dividend pay out ratio will decrease the growth rate from the above formula.

As for in the case of PE-Ratio,

PE-Ratio = Dividend payout / ( required rate of return - dividend growth rate)

Since dividend payout appears in the numerator, an increase in dividend payout ratio will only increase PE-Ratio