Consider the following information about an automobile manufacturer:
Next annual dividend: $4.11 -
Earnings per share next year: $7.02
Anticipated growth rate: 6% per year
Required rate of return: 11% per year
What is the expected earnings multiplier for this utility company?
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To determine the earnings multiplier (i.e. the price-to-earnings ratio) for an individual company, use the following formula:
P/E = [(d1 / e1) / (k - g)]
Where: P/E = the earnings multiplier, d1 / e1 = the dividend payout ratio at t1, k = the required rate of return, and g = the anticipated future growth rate.
In this example, all of the necessary information has been provided, but some rearranging is necessary. Specifically, the dividend payout ratio must be determined. This figure is found as follows:
Dividend payout ratio = [$4.11 / $7.02] = 0.58547, or 58.55%
Now that the dividend payout ratio has been determined, we can solve for the appropriate earnings multiplier. The calculation of this figure is found as follows:
P/E = [0.5855 / (0.11 - 0.06) = 11.71
In generally favorable economic conditions, this is a realistic earnings multiple for an average automobile manufacturer.