Suppose that the consensus forecast of security analysts of your favorite company is that earnings next year will be $5.00 per share. The company plows back 50% of its earnings and if the Chief Financial Officer (CFO) estimates that the company’s return on equity (ROE) is 16%. Assuming the plowback ratio and the ROE are expected to remain constant forever:

If you believe that the company’s required rate of return is 10%, what is your estimate of the price of the company’s stock?

Answer:

$250

Step-by-step explanation:

according to the constant dividend growth model

price = d1 / (r – g)

d1 = next dividend to be paid

r = cost of equity

g = growth rate

Sustainable growth rate is the rate of growth a company can afford in the long term

sustainable growth rate = plowback rate x ROE

b = plowback rate. It is the portion of earnings that is not paid out as dividends

g = 0.50 x 0.16 = 0.08 = 8%

5 / (10% – 8%)

5 / 2%

5 / 0.02 = $250