A finance major works evenings as an intern at Churn Brothers Brokerage. As a test of her abilities, this intern has been asked to calculate the earnings multiplier of a software index. The firms that comprise this index are all high-technology names for whose products there exists great demand. Further, this demand is expected to be explosive in the future and the earnings visibility of these software firms is clear, reliable, and concise.
In her research of the software index, the intern has gathered the following information:
EPS: 0.39 -
k: 62% per year
g: 60% per year
D1: 0.02 -
Using this information, what is the earnings multiplier of this software index? Further, is this earnings multiplier realistic given the demand for the firms' products and the visibility of future earnings?
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A. B. C. D. E. F.E
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 = [($0.02*1.6 / ($0.39*1.6)) / (0.62 - 0.60)] = 2.56
This is an extremely low multiple, appropriate for virtually no-growth industries. The fact that the index under examination is a compilation of firms in high-tech software business, for whose products there exists great demand and promise of future growth, this low multiple seems very unrealistic. Consider the fact that the
P/E ratio is a proxy for future growth. Firms in the automobile, basic materials, or other mature industries, which are expected to grow slowly, are characterized by lower earnings multiples and higher dividend payout ratios. Firms in the software, networking, biotechnology, and other high-growth industries, are typically characterized by high earnings multiples and low dividend payout ratios. What is happening here is that investors are giving up current income (i.e. dividends) in the hopes of rapid earnings growth (i.e. greatly increased EPS in the future).