Suppose that the consensus forecast of security analysts of your favorite company is that earnings next year will be $5.00 per share. The co

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?

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  1. 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

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