(Valuing common Stock) Assume the following: • The investor’s required rate of return is 15 percent. • The expected level of earnings at the end of this year (E1) is $5.00. • The retention ratio is 50 percent. • The return on equity (ROE) is 20 percent (that is, it can earn 20 percent on reinvested earnings). • Similar shares of stock sell at multiples of 10 times earnings per share. A. Determine the price/earnings ratio (P/E1) B. What is the stock price using the P/E ratio valuation method? C. What is the stock price using the dividend discount model? D. What would happen to the P/E ratio (P/E1) and stock price if the firm could earn 25 percent on reinvested earnings (ROE)? E. What does this tell you about the relationship between the rate the firm can earn on reinvested earnings and the P/E ratio?
Dividend Valuation
Dividend refers to a reward or cash that a company gives to its shareholders out of the profits. Dividends can be issued in various forms such as cash payment, stocks, or in any other form as per the company norms. It is usually a part of the profit that the company shares with its shareholders.
Dividend Discount Model
Dividend payments are generally paid to investors or shareholders of a company when the company earns profit for the year, thus representing growth. The dividend discount model is an important method used to forecast the price of a company’s stock. It is based on the computation methodology that the present value of all its future dividends is equivalent to the value of the company.
Capital Gains Yield
It may be referred to as the earnings generated on an investment over a particular period of time. It is generally expressed as a percentage and includes some dividends or interest earned by holding a particular security. Cases, where it is higher normally, indicate the higher income and lower risk. It is mostly computed on an annual basis and is different from the total return on investment. In case it becomes too high, indicates that either the stock prices are going down or the company is paying higher dividends.
Stock Valuation
In simple words, stock valuation is a tool to calculate the current price, or value, of a company. It is used to not only calculate the value of the company but help an investor decide if they want to buy, sell or hold a company's stocks.
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