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.

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?

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?

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.

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)