The P/E ratio of a stock equals 7.1. The company has just released its earnings figures at $12.20 per share. The firm's dividend payout ratio is 28%. If the current stock price is $100, what is its 1-year expected return under the Dividend Discount Model?
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A. B. C. D.Explanation
It is important to remember that the P/E ratio is the ratio of the current stock price and next year's expected earnings. Therefore, the firm's expected earnings next year equal 100/7.1 = $14.09 per share. Since the current earnings equal $12.2, the dividend growth rate equals (14.09/12.2 - 1) = 15.45%.
To get the 1-year expected return, first calculate the expected price next year. Under Dividend Discount Model, the P/E ratio remains constant if the firm makes no policy changes and there are no market disruptions. Therefore, price next year is expected to be $14.09*(1 + 15.45%)*7.1 = $115.45. The dividend next year equals $14.09 * 0.28 = $3.95 per share. Thus, 1-year expected return (capital gains + dividends) = (P1+D1)/Po = (115.45 + 3.95)/100 - 1 = 19.4%.