Question

4. The blue company has ROE = 25%; growth in EPS = 4.5%; payout ratio of 35% and investors required return of 12.5%. Calculate the price to book value ratio.

If P/BV = 2.5 you will buy_________ you will sell__________

                5.a) If the payout ratio is 35% and net profit margin is 4.5% with a growth rate of 5%, calculate price to sales ratio if you require a 11% return on investment.

b) If sales rise by $1.25 per share, what would be the change in stock price?

Answer 1

A	B	C	D	E	F	G	H	I	J	K
2		Price to book ratio is calculated as follows:
3		Price to Book Value	=Price Per share / Book Value Per share
4		Using dividend growth model, current price of share is calculated as follows:
5		Price per Share	=Div0*(1+g) / (r-g)
6		Where Div0 is the dividend paid today, g is the dividend growth rate and r is the required rate of return.
7		Div 0	=EPS0*b
8		where b is the payour ratio
9		Thus Growth rate in EPS will be the growth rate of the dividend.
10
11		Price per share	=Div0*(1+g) / (r-g)
12			=EPS0*b*(1+g) / (r-g)
13
14		Return on equity is given as follows:
15		Return on equity	=Net Income / Shareholders' Equity
16			=EPS0 / BV per share
17
18		Price to book value formula can be written as follows:
19		Price to Book Value	=Price Per share / Book Value Per share
20			=[EPS0*b*(1+g)/(r-g)]/BV Per share
21			=ROE*b*(1+g)/(r-g)
22
23		Using the given data,
24		ROE	25%
25		b	35%
26		g	4.50%
27		r	12.50%
28
29		Price to Book Value	=ROE*b*(1+g)/(r-g)
30			=25%*35%*(1+4.5%)/(12.5%-4.5%)
31			1.14
32
33		Hence Price to book value ratio should be	1.14
34
35		If P/B is 2.5 at present, then the higher price is being paid for the book value of the company than the actual,
36		therefore, the company stock is overvalued and the shares of the company should be sold.
37