An analyst with Smith, Kleen & Beetchnutty is trying to determine the earnings multiple of a stock market series composed of firms in the basic materials business.
In her research, the analyst has gathered the following information:
D1: $1.10 -
EPS: $4.30 -
k: 13.75% per year
g: 10.50% per year
Using this information, what is the earnings multiplier of this stock market series? Further, is this multiple realistic for firms in the basic materials business?
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A. B. C. D. E. F.D
To determine the earnings multiplier, or "P/E ratio," of a stock market series, use the following equation: P/E = [(D1 / E1) / (k-g)
Where: D1 = the annual per-share dividend at t1, E1 = the EPS figure at t1, k = the required rate of return on common stock, and g = the expected growth rate of dividends.
In this example, all of the necessary information has been provided, and putting it into the equation above will yield the following:
P/E of a stock market series = [($1.10*1.105 / ($4.30*1.105)) / (0.1375 - 0.105)] = 7.88
This is a rather low multiple, appropriate for slow growth industries. The fact that the index under examination is a compilation of firms in the basic materials business substantiates this low multiple because firms in this line of business are not expected to grow very rapidly. Further, firms in the basic materials business are also likely to have a relatively high dividend payout ratio, as evidenced in this example.