A portfolio manager is attempting to determine the earnings multiple for an index of technology companies, and has gathered the following information:
D1: $0.20 -
EPS: $1.44 -
k: 28% per year
g: 26.5% per year
Using the information provided, what is the price-to-earnings ratio for this technology index? Further, is this earnings multiple realistic assuming that the demand for technology is great, earnings visibility is clear, and the industry is expected to grow rapidly? To solve for P/E, manipulate the infinite period dividend discount model.
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A. B. C. D. E. F.C
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 = [($0.20 *1.265/ ($1.44*1.265)) / (0.28 - 0.265)] = 9.26
This is a rather low multiple, appropriate only for slow growth industries or specific situations such as industries with high risk or uncertainty. The fact that the index under examination is a compilation of firms in the high tech business, where demand is expected to be great, does not logically lead to this low of an earnings multiple. The fact that earnings visibility is clear augments this. The reasoning behind this is the fact that firms in the technology sector are expected to grow very rapidly, i.e. they should merit higher earnings multiples. Think of a P/E ratio as a proxy for future earnings growth. In this situation, a multiple of less than 10 seems unrealistic.