Question

ENN Inc. expects to earn $2 per share in year 1. The company has a policy of retaining 60 percent of its earnings and investing them at a return (R) of 20 percent. Stockholders in EG expect a return (K) of 15 percent on the stock.

                          

1. What price should ENN’s stock sell for?
2. What is the premium for growth and the PE ratio

The company has just come up with a new highly profitable product. As a result it plans to retain all earnings for the next 3 years (i.e. b=1) and invest them at a return (R) of 100% per year. After three years the company will go back to its old policy of retaining 60 percent of its earnings and investing them at 20 percent.

3. What will be the new price of the stock?
4. The new PE ratio
5. The new premium for growth?

Answer 1

Current earnings per share = $2

Retention ratio = 60%

Payout ratio = 100%-60% = 40%

r = 15%

g = 0.6*20% = 12%

Current price(Po) = (Next year dividend)(r-g)

Po = 2*0.4/(0.15-0.12) = $26.666

Current EPS = $2

Current stock price = $26.666

P/E ratio = 26.666/2= 13.33

Hence P/E ratio = 13.33

Had there been no growth

Current EPS = 2/(1+0.6*0.2) = 1.786

Current stock price (with no growth) = 1.786/0.15 = $11.91

Growth premium = Stock price with growth - Stock price without growth = 26.666 - 11.91 = $14.756

After the new highly profitable product

EPS after 3 years = (2/1.12) * 2^3 = $14.286

Payout ratio = 100%-60% = 40%

r = 15%

g = 12%

The stock price at the end of year 3 =

P3 = 14.286*0.4*1.2/(0.15-0.12) = $228.576

Current price is discounted price at 15% of price after year 3 = 228.576/(1.15^3)

New stock price =$150.30

New P/E ratio = 150.30/2= 75.15

Had there been no growth, stock price = $11.133

Growth premium = Stock price with growth - Stock price without growth = 150.30- 11.133 = $139.17