schweser practice exam I next, practice, expected, provided

siavosh

This is a simple question. However, I got stuck in one simple calculation provided by the answer. Would really appreciate if someone can clarify it.
It’s exam I morning section #9-c, calculating expected rate of return. It uses P/E multiples to get the stock price for next period. However, it gets required return of 10.5%, g of 6.825%, using the formula of d1/(r-g) should get the current stock price. How come it uses such formula to get the next period stock price?
Thanks in advance.

ba736

Basically, when you are using the earning mulitiplier approach, you are using a justified PE to estimate the fair value of a stock price. For example if we think that a reasonable price for stock A should trade at a PE of 10. We would use this PE to estimate the fair value of the stock once we have the forecast EPS for next year. Example if foward EPS is 5 cents then the fair value of the share price now should be 50 cents.
Actually, the required return of 10.5% can also be derived by using the formula: D1/P + g = 10.575%.
The formula for the justified PE is :
P = D1/ (r-g)
Dividing by E on both side, you get
P/E = D1/E / (r-g) which is
P/E = Dividend payout ratio/ (r-g)

JustasS

Thanks a lot for the reply. I used the same formula, however, the number doesn’t tight. It gave us next period dividend of $1.5 and next period of earnings of $5.
We can get g=ROE(1-K)=6.825%, required return r= 4%+6.5% = 10.5%, so current stock price should be d1/(r-g)=40.816 which is actually the price they calculated for next period. And they gave us the current stock price of $40. Thus, the data doesn’t seem to tight. Any explanation? Thanks.

dmrktrading

I forget the question…
But I think it was something like (40.816 - 40.0 +1.5) / 40.0 = 0.0579
did you forget to include the dividend in calculating the return?

tikfed

no. i agree it should be (p1-p0+d1)/p0. problem is how did they come up with p1?
p0/E1 = k/(r-g), however, they make it as p1/E1 = k/(r-g). which one is the correct formula?