CFA® Level 1: CFA® Level 1 Exam Preparation

Determining Earnings Multiplier and Value for a Stock Market Series

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Question

An economist with Smith, Kleen & Beetchnutty Institutional Brokerage has been examining a stock market series and is trying to determine an appropriate earnings multiplier for the series. In her research, this economist has determined the following information:

The annual dividend at t1 = $1.35

The EPS at t1 = $5.10 -

The anticipated growth rate of dividends is 12.5%

The anticipated growth rate of earnings is 14%

The required rate of return is 15.75%

Using this information, what is the appropriate earnings multiplier for this stock market series? Further, what is the appropriate value for this stock market series?

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A. B. C. D. E. F.

E

The appropriate earnings multiplier is found to be 8.14. Estimating the earnings multiplier for a stock market series requires the estimation of each of the following components:

1. The dividend payout ratio.

2. The required rate of return on common stock in the country/region/industry/sector being analyzed.

3. The expected growth rate of dividends for the stocks in the country/region/industry/sector being analyzed.

Once values for each of these components have been determined, they are imputed into the following formula: {P/E = [D/E / (k - g)]}. Where: P/E = the earnings multiplier, or Price-to-Earnings ratio, D/E = the dividend payout ratio at t1, k = the required rate of return, and g = the anticipated growth rate of dividends.

In this example all of the necessary information has been provided. However, the dividend payout ratio must be calculated based on the anticipated dividend at t1 and the projected EPS figure for t1. The calculation of the dividend payout ratio is as follows: {D/E = [$1.35 / $5.10] = 0.264706}. Now that the dividend payout ratio has been determined, the appropriate earnings multiplier is found as follows: {P/E =

[0.264706/ (0.1575 - 0.125)] = 8.14. Notice that it is the anticipated growth rate of dividends, not the anticipated growth rate of earnings, which is used in the determination of the earnings multiplier.

Multiplying this figure by the projected EPS will lead to an appropriate value of $41.51 for this series.

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