Question

The market consensus is that Analog Electronic Corporation has an ROE of 9% and a beta of 2.05. It plans to maintain indefinitely its traditional plowback ratio of 2/3. This year's earnings were $3.8 per share. The annual dividend was just paid. The consensus estimate of the coming year's market return is 15%, and T-bills currently offer a 5% return.

a. Find the price at which Analog stock should sell. (Do not round intermediate calculations. Round your answer to 2 decimal places.)

b. Calculate the P/E ratio. (Do not round intermediate calculations. Round your answers to 2 decimal places.)

c. Calculate the present value of growth opportunities. (Negative amount should be indicated by a minus sign. Do not round intermediate calculations. Round your answer to 2 decimal places.)

d. Suppose your research convinces you Analog will announce momentarily that it will immediately reduce its plowback ratio to 1/3. Find the intrinsic value of the stock. (Do not round intermediate calculations. Round your answer to 2 decimal places.)

Answer 1

Retention Ratio, R = 2/3; ROE = 9%; Beta = 2.05

Growth rate, g = R x ROE = 2/3 x 9% = 6%

Divided payout ratio = DPO = 1 - R = 1 - 2/3 = 1/3

E1 = E0 x (1 + g) = 3.8 x (1 + 6%) = $ 4.028

D1 = E1 x DPO = 4.028 x 1/3 = 1.3427

Cost of equity, Ke = Rf + Beta x (Rm - Rf) = 5% + 2.05 x (15% - 5%) = 25.50%

Part (a)

the price at which Analog stock should sell, P0 = D1 / (Ke - g) = 1.3427 / (25.5% - 6%) = $ 6.89

Part (b)

Leading P/E ratio = P0 / E1 = 6.89 / 4.028 = 1.71

Trailing P/E ratio = P0/E0 = 6.89 / 3.80 = 1.81

Part (c)

PVGO = P0 - E1/Ke = 6.89 - 4.028 / 25.50% = - 8.91 (Please note there is a negative sign before the figure)

Part (d)

Retention Ratio, R = 1/3; ROE = 9%; Beta = 2.05

Growth rate, g = R x ROE = 1/3 x 9% = 3%

Divided payout ratio = DPO = 1 - R = 1 - 1/3 = 2/3

E1 = E0 x (1 + g) = 3.8 x (1 + 3%) = $ 3.914

D1 = E1 x DPO = 3.914 x 2/3 = 2.61

Cost of equity, Ke = Rf + Beta x (Rm - Rf) = 5% + 2.05 x (15% - 5%) = 25.50%

the intrinsic value of the stock, P0 = D1 / (Ke - g) = 2.61 / (25.5% - 3%) = $ 11.60