Assume the following information about a stock market series:
Retention rate at t1 = 70%
Expected growth rate of dividends at t1 = 8%
Expected growth rate of earnings at t1 = 20%
Required rate of return = 15%
Given this information, what is the appropriate earnings multiplier for this stock market series? Further, what is the value of this series?
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A. B. C. D. E. F.D
The answer cannot completely be determined from the information provided. Specifically, while the appropriate earnings multiplier can be found from the given information (and it is found as 4.29), the correct value for the series cannot be determined without an estimation of EPS at t1. The following explains the derivation of the earnings multiplier for a stock market series.
Estimating the earnings multiplier for a stock market series requires the estimation of each of the following components:
1. The dividend payout ratio.
2. The required rate of return on common stock in the country/region/industry/sector being analyzed.
3. The expected growth rate of dividends for the stocks in the country/region/industry/sector being analyzed.
Once values for each of these components have been determined, they are imputed into the following formula:
{P/E = [D/E / (k - g)]}. Where: P/E = the earnings multiplier, or Price-to-Earnings ratio, D/E = the dividend payout ratio at t1 [remember this is equal to (1 - the retention rate)], k = the required rate of return, and g = the anticipated growth rate of dividends.
Had this example provided a figure for the EPS at t1, then the value of the index could be found by multiplying the EPS at t1 by the earnings multiplier. The earnings multiplier of 4.29 is calculated as (1-Payout ratio)/(required rate of return-growth rate) = (1-.7)/(.15-.08) = 4.29.