An investor is examining shares of Intelligent Semiconductor to determine if they are trading at an appropriate multiple. Assume the following information: k = 14.25% per year g = 13.4% per year
D0 = $2.15 -
P0 = $110.80 -
Using the information provided, what is the appropriate P/E ratio for Intelligent Semiconductor?
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A. B. C. D. E. F.B
In this example, not all of the necessary information has been provided. Specifically, the EPS figure must be known in order for the P/E ratio to be determined.
If the EPS figure is known, however, the infinite period dividend discount equation can be manipulated to solve for the P/E multiple. Specifically, 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:
P0/EPS = (D1 / EPS)/(k-g)
Where: P0 = the price of the common stock at t0, 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.