CFA Level 1: Firm's Price/Earnings Ratio Calculation

Firm's Price/Earnings Ratio Calculation

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Question

A firm has an expected dividend payout ratio of 50%, and an expected dividend growth rate of 6% per year. What is the firm's Price/Earnings ratio if the appropriate discount rate is 10% per year?

Answers

Explanations

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A. B. C. D.

C

Value = 0.50/(0.10-0.06) = 12.5.

To calculate the firm's Price/Earnings (P/E) ratio, we need to use the dividend discount model (DDM) formula, which is commonly used to value stocks. The formula for the DDM is as follows:

P0=D1r−gP_0 = \frac{D_1}{r - g}

Where:

  • P0P_0 represents the current stock price.
  • D1D_1 represents the expected dividend for the next period.
  • rr represents the discount rate or required rate of return.
  • gg represents the expected dividend growth rate.

In this case, we are given the expected dividend payout ratio of 50% and an expected dividend growth rate of 6% per year. However, we are not provided with the dividend value itself (i.e., D1D_1). Without this value, we cannot calculate the P/E ratio.

Therefore, the correct answer is B. "Not able to compute with the above data."

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