The market consensus is that Analog Electronic Corporation has an ROE = 6% and a
ID: 2717352 • Letter: T
Question
The market consensus is that Analog Electronic Corporation has an ROE = 6% and a beta of 1.30. It plans to maintain indefinitely its traditional plowback ratio of 1/3. This year's earnings were $3.0 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. Find the price at which Analog stock should sell. Calculate the P/E ratio. Calculate the present value of growth opportunities. Suppose your research convinces you Analog will announce momentarily that it will immediately reduce its plowback ratio to 2/3 Find the intrinsic value of the stock.Explanation / Answer
Answer:-
a. Find the price at which analog stock should sell
k = rf+beta*(rm-rf) = 5%+1.30*(15%-5%) = 18%
g = ROE X b = 6%*1/3 = 6%*.0333 = 2%
g = groth rate, b = Plowback ratio
D 1 = E 0 (1 + g) (1 – b) = $3(1.02) (2/3) = $2.04
P0 = D1/(k-g) = 2.04/(0.18-0.02) = 2.04/0.16 = $12.75
b. Calculate the P/E ratio
Leading P0/E1 = $12.75/$/$3.06 = 4.17 Where E1 = 3*(1+g)
Trailing P0/E0 = $12.75/$3 = $4.25
c. Calculate the present value of growth opportunities
PVGO = P0-E1/k = $12.75-$3.06/0.18 = -$4.25
The low P/E ratios and negative PVGO are due to a poor ROE (6%) that is less than the market capitalization rate (18%).
d. Find the intrinsic value of the stock
Revised Plowback ratio (b) = 2/3;
g = ROE x b = .06 x 2/3 = 0.04;
D 1 = E 0 x (1 + g) x (1 – b) = 3 x (1.04) x (1/3) = $1.04
Intrinsic value (V 0 ) = $1.04 / (0.18 – 0.04) = $7.43
Related Questions
Navigate
Integrity-first tutoring: explanations and feedback only — we do not complete graded work. Learn more.