Analytics Software Incorporated currently pays 20% of its earnings in dividends and the Company has a steady growth rate of 25% per year. Assuming a 27.5% per year required rate of return, what is the appropriate earnings multiplier for Analytics Software?
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A. B. C. D. E. F.E
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, and the calculation of the earnings multiplier is as follows:
P/E = [0.20 / (0.275 - 0.25)] = 8
This multiplier is likely low for a software firm growing at 25% annually. An analyst examining shares of Analytics Software would likely take this disparity into account in his or her analysis. Perhaps the use of the Infinite Period DDM to determine an earnings multiplier for this company is unrealistic. Perhaps valuing this company in accordance to anticipated free cash flows would provide a more realistic measure of value.