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6. Constant-growth rates

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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.

Sam Cho, an equity research analyst at Cho 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.

Sam has the following information available:

Based on the information just given, Sam’s forecast of PAMC’s growth rate should be selector 1

10.75%

9.00%

6.00%

4.98%

.

Points:

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Explanation:

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

All else being equal, growth in dividends requires growth in earnings.

Retaining a higher percentage of earnings will result in a lower growth rate.

Long-run earnings growth will decrease when firms retain earnings and reinvest them in the business.

• Pan Asia Mining Co’s stock (Ticker: PAMC) is trading at 22.50 per share. • The company’s stock is expected to pay a year-end dividend of $1.08 that is expected to grow at a certain—currently unknown—rate. • The stock’s expected rate of return is 10.80%.

Explanation / Answer

1. According to DCF, the cost of equity (Ke) = D1/p0 + g

Ke =10.80% = 0.108

D1 =1.08

P0 = 22.50

g = ?

0.108 = 1.08/22.50 + g

g = 0.108 - 1.08/22.50

g = 0.108 - 0.0048

g = 0.06 = 6%

PAMC’s growth rate should be 6.00% for selector 1

2. Which of the statement is correct

Answer - All else being equal, growth in dividends requires growth in earnings

Explnation : Retaining a higher percentage of earnings will result in a higher growth rate (statement 2 incorrect) and Long-run earnings growth will increase when firms retain earnings and reinvest them in the business (statement 3 is alos incorrect). Only the first statement is correct

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