Question

7. Constant growth rates

One of the most important components of stock valuation is a firm’s estimated growth rate. Financial statements provide the information needed to estimate the growth rate.

Consider this case:

Robert Gillman, an equity research analyst at Gillman Advisors, believes in efficient markets. He has been following the mining industry for the past 10 years and needs to determine the constant growth rate that he should use while valuing Pan Asia Mining Co.

Robert has the following information available:

•	Pan Asia Mining Co.’s stock (Ticker: PAMC) is trading at $16.25.
•	The company has forecasted net income and book value of equity for the coming year to be $1,025,700 and $8,027,500, respectively.
•	The company has also been paying dividends for the past eight years and has maintained a dividend payout ratio of 32.500000%.

Based on this information, Robert’s forecast of PAMC’s growth rate in earnings and dividends should be:

8.62%

20.77%

15.98%

6.23%

Which of the following statements accurately describes the relationship between earnings and dividends when all other factors are held constant?

Long-run earnings growth occurs primarily because firms retain earnings and reinvest them in the business.

Paying a higher percentage of earnings as dividends will result in a higher growth rate.

Dividend growth and earnings growth are unrelated.

Answer 1

Solution-1:

Current Stock Price of Pan Asia Mining Co = $16.25

Expected Book Value of Equity = $8,027,500

Expected Net Income = $1,025,700

Return on equity = Expected Net Income / Expected Book Value of Equity * 100

= $1,025,700/$8,027,500 * 100

= 12.7773279%

.

Dividend Payout Ratio = 32.5 %

Retention Ratio = (100 - 32.5) = 67.5 % or 0.675

.

Sustainable Growth Rate = Retention Ratio x ROE = 0.675 x 12.7773279%

= 8.6247 %

= 8.62 %

.

Solution-2:

The following statements accurately describes the relationship between earnings and dividends when all other factors are held constant:

Long-run earnings growth occurs primarily because firms retain earnings and reinvest them in the business.