James Fry, CFA, is evaluating the potential investment merit of Cushing Corporation. Cushing's most recent year's earnings were S5.00 per share, and Cushing paid a dividend of $1.50 per share. Fry forecasts that Cushing will cam $4.70 per share next year. Fry estimates Cushing's future growth rate will be 10%, with a required rate of return of 12%. Based on the information provided, calculate Cushing's leading price to earnings (P/E) ratio. If the required rate of return is increased, indicate whether Cushing's P/E ratio will be higher or lower.
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A. B. C.Explanation
To calculate Cushing Corporation's leading price-to-earnings (P/E) ratio, we need to divide the stock price by the earnings per share (EPS). The EPS for the most recent year is given as $5.00 per share.
The P/E ratio can be calculated as follows:
P/E ratio = Stock Price / EPS
However, the stock price is not given directly in the question. We can use the dividend discount model (DDM) to estimate the stock price based on the dividend and the required rate of return.
The DDM formula is as follows:
Stock Price = Dividend / (Required Rate of Return - Growth Rate)
Given that the dividend is $1.50 per share and the required rate of return is 12%, we can substitute these values into the formula:
Stock Price = $1.50 / (0.12 - 0.10) = $1.50 / 0.02 = $75
Now, we can calculate the P/E ratio:
P/E ratio = $75 / $5.00 = 15.0
Therefore, the correct answer is A. The P/E ratio is 15.0.
Next, let's consider the effect of increasing the required rate of return on Cushing's P/E ratio.
If the required rate of return increases, it means that investors will demand a higher return for investing in Cushing's stock. This higher required rate of return would typically result from increased perceived risk associated with the stock or changes in the overall market conditions.
When the required rate of return increases, it would generally lead to a decrease in the stock price. This is because a higher required rate of return reduces the present value of future earnings and dividends, making the stock less valuable.
Since the P/E ratio is calculated by dividing the stock price by earnings per share, a decrease in the stock price (due to an increase in the required rate of return) would result in a lower P/E ratio.
Therefore, the correct answer is B. An increase in the required rate of return would result in a lower P/E ratio.
In summary, Cushing Corporation's leading P/E ratio is 15.0, and an increase in the required rate of return would lead to a lower P/E ratio.