Mermen, Inc., a manufacturer of male swimwear, has a return on equity of about 7.2%. It typically pays out about 33% of its earnings as dividends. The firm's stock has a covariance with the market of 0.045. The market has an expected return of 12.9% and a standard deviation of 19.4%. The prevailing risk-free rate is
4.9% and Mermen's stock return has a standard deviation of 23%. Most analysts in the market are of the opinion that Mermen's EPS next year is likely to be around $9.20 per share. Given these data,
Mermen's share price should be about:
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A. B. C. D.C
The CAPM expected rate of return on the stock is equal to the risk-free rate plus beta times the market premium. The beta of the stock equals 0.045/(0.194 * 0.23)
= 1.01. So the expected return on Mermen's stock is 4.9% + 1.01*(12.9 - 4.9)% = 12.98%.
The Dividend Discount Model implies that Mermen's share price is given by Po = D1/(k-g), using standard notation. We have D1 = 0.33 * 9.2 = $3.036. The dividend growth rate is given by g = ROE*(1-dividend payout ratio) = 7.2% * 0.67 = 4.824%. The price of the stock then equals 3.036/(12.98% - 4.824%) = $37.22.