Common Stock Valuation

The investors required rate of return of 13.5%,

The expected level of earnings at the end of this year (E₁) is $6.00,

The retention ratio is 50%,

The return on equity (ROE) is 15% (that is, it can earn 15% on reinvested earnings), and

Similar shares of stock sell at multiples of 16.667 times earnings per share

Questions:

a. Determine the expected growth rate for dividends.

b. Determine the price earnings ratio (P/E1).

c. What is the stock price using the P/E ratio valuation method?

d. What is the stock price using the dividend discount model?

e. What would happen to the P/E ratio (P/E1) and stock price if the company increased its retention rate to 60% (holding all else constant)? What would happen to the P/E ratio (P/E1) and stock price if the company paid out all its earnings in the form of dividends?

f. What have you learned about the relationship between the retention rate and P/E ratios?