Question

1. Differentiate between each of the following terms:                                                                (6)
   1. Earnings Yield,
   2. Dividend Yield,
   3. PE Ratio.
2. List four most important factors that would influence an investment analyst in the rating

of PE ratios.                                                                                                                            (4)

3. The firm projects a ROE of 25%; it will maintain a plowback ratio of 0.3. The firm is

expecting earning of R5 per share and investors expect a return of 10% on the stock.

What is the expected price and P/E ratio of the firm?

Answer 1

Earnings Yield : The earnings per share for last 12 months divided by the current market price of the share. It is expressed in % terms. A shareholder will prefer a higher earnings yield. It is the inverse of P/E ratio.

Earnings Yield = Last Twelve month EPS / Current market price

Dividend Yield : It is the dividend earned during the last 12 months divided by current market price. It is expressed as a percentage. For a share holder this is incremental earning over the capital gains

Dividend yield = Dividend earned during the year / Current market price

P/E Ratio : The current market price divided by the EPS per share. It is expressed as a ratio. This is one of the most significant financial ratio. It could be based on current EPS (last 12 months) or forward earnings (Next 12 months). It is used to assess the value of stock with its peer group. A stock with lower P/E ratio than industry peers is considered to be a undervalued stock.

P/E Ratio = Current Market Price / Earnings per share

An analyst would rate the P/E ratio with respect to the peer group

An analyst is more likely to use the forward P/E ratio

An analyst with compare the P/E ratio with in the industry segment

An analyst will also check the growth rate of the company along with P/E by using PEG ratio. High growth stocks can enjoy a higher P/E ratio

RoE = 25%

Plow back Ratio = 0.30

The long term growth of the stock = RoE x Plowback ratio

= 25% x 0.30

= 7.50%

Price of share = D1 / (k -g)

Dividend = 5 X (1-0.30) = 3.50

where, D1 = Next year dividend (3.50)

g = Long period growth rate (7.50%)

k = Expected return (10%)  

Expected Price of the share = 3.50 / (10% - 7.50%)

= 3.50 / 2.5%

= R140

The PE ratio =

Price/ EPS

= 140 / 5

= 28 times