Clay Industries Price-to-Earnings Ratio Calculation

Price-to-Earnings Ratio Calculation for Clay Industries

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Question

An intern with Churn Brothers Brokerage has been asked to calculate the Price-to-earnings ratio for Clay Industries. She has been provided with the following information:

D0 = $1.25 -

g = 12% per year

k = 15.5% per year

Earnings per share: $2.78 -

Using this information, what is the price-to-earnings ratio for Clay Industries?

Answers

Explanations

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Explanation

By dividing each side of the infinite period dividend discount equation by the EPS figure, it is possible to determine the P/E ratio. This is illustrated as follows:

P/E = (D1 / EPS)/(k-g)

Where: D1 = the dividend at t1, EPS = the earnings per share calculation for t1, k = the required rate of return, and g = the expected growth rate.

Manipulating the infinite period dividend discount model to solve for the PE is a rather intuitive process.

Consider the fact that an investment's value is truly nothing more than the present value of all future returns. So said, dividing both sides of the infinite period dividend discount model equation by the EPS figure should yield the appropriate multiple, or "earnings multiplier." This is the price-to-earnings ratio.

In this example, we are provided all of the necessary information. However, the dividend at t1 must be calculated manually by multiplying D0 by (1 + growth rate).

This will yield a figure of $1.40 for D1.

Now that D1 has been determined, we can solve for the P/E. Imputing all the given information into the equation provided above will yield the following:

P/E = ($1.40 / $2.78) / (15.5% - 12%) = 14.39

If you chose 12.85, remember that it is the dividend at t1 that is used in the determination of the P/E, not the dividend at t0.