Suppose that a firm’s recent earnings per share and dividend per share are $2.50

Question

Suppose that a firm’s recent earnings per share and dividend per share are $2.50 and $1.30, respectively. Both are expected to grow at 10 percent. However, the firm’s current P/E ratio of 18 seems high for this growth rate. The P/E ratio is expected to fall to 14 within five years.

Compute the dividends over the next five years. (Do not round intermediate calculations and round your final answers to 3 decimal places.)

Compute the value of this stock price in five years. (Do not round intermediate calculations and round your final answer to 2 decimal places.)

Calculate the present value of these cash flows using a 12 percent discount rate. (Do not round intermediate calculations and round your final answer to 2 decimal places.)

Suppose that a firm’s recent earnings per share and dividend per share are $2.50 and $1.30, respectively. Both are expected to grow at 10 percent. However, the firm’s current P/E ratio of 18 seems high for this growth rate. The P/E ratio is expected to fall to 14 within five years.

Explanation / Answer

1) Dividend in the next five years

D1 = $ 1.30 + (1+.10) = $1.430

D2 = $ 1.430 + (1+.10) = $ 1.573

D3 = $ 1.573 + (1+.10) = $ 1.730

D4 = $ 1.730 + (1+.10) = $ 1.903

D5 = $ 1.903 + (1+.10) = $ 2.093

2) stock price in 5 years

14 * $ 2.50 *(1.10)5 = $ 56.37

3) Present value of cash flows

1.430/ 1.12 + 1.573 / (1.12)2+ 1.730 / (1.12)3+ 1.903 / (1.12)4+ 2.093/ (1.12)5

= 1.430*0.893 + 1.573*0.797 + 1.730*0.712 + 1.903*0.636 + 2.093*0.567

= 1.276 + 1.253 + 1.231 + 1.210 + 1.186

= $ 6.157

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