Find the price at which Analog stock should sell.

QUESTION

The market consensus is that Analog Electronic Corporation has an ROE 5 9%, has a beta of 1.25, and plans to maintain indefinitely its traditional plowback ratio of 2/3. This years earnings were $3 per share. The annual dividend was just paid. The consensus estimate of the coming years market return is 14%, and T-bills currently offer a 6% return.
a. Find the price at which Analog stock should sell.
b. Calculate the P/E ratio.
c. Calculate the present value of growth opportunities.
d. Suppose your research convinces you Analog will announce momentarily that it will immediately reduce its plowback ratio to 1/3. Find the intrinsic value of the stock. The market is still unaware of this decision. Explain why V0no longer equals P0and why V0is greater or less than P 0.
Solution: a) Cost of Equity = Rf + *[(Rm) Rf ] = .6% + 1.25*(14% 6%) = 16% G = ROE*plowback ratio = 9%*2/3 = 6% D1 = E0*(1 + g)*(1 plowback ratio) = 3*(1 + 6%)*(1 2/3) = $1.06 P0 = D1/(Ke g) = 1.06 /(16% 6%) Price = $10.60 b) G = ROE*(1 D1 / EPS1) = 9%*(1 1.06 / EPS1) = 6% Solving for EPS1 = $3.18 Leading P0/E1 = 10.60 / 3.18 = 3.33 Trailing P0/E0 = 10.60 / 3.00 = 3.53 c) PV of growth opportunities = (P0

E1) / Ke = (10.60 3.18) / 16% = $9.275 d) G = 9%*1/3 = 3% D1 = 3*(1 + 3%)*(1 1/3) = $2.06, The intrinsic value of the stock, V0 = D1 / (Ke g) = 2.06 / (16% 3%) = $15.85 Explanation: Value increases because of paying more earnings and not because of reinvesting a poor ROE.

ANSWER:

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