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Essentials Of Investments
Found in: Page 440
Essentials Of Investments

Essentials Of Investments

Book edition 9th
Author(s) Zvi Bodie, Alex Kane, Alan Marcus, Alan J. Marcus
Pages 748 pages
ISBN 9780078034695

Short Answer

Peninsular Research is initiating coverage of a mature manufacturing industry. John Jones, CFA, head of the research department, gathered the following fundamental industry and market data to help in his analysis:

Forecast Industry earnings retention rate


Forecast industry returns on equity


Industry beta


Government bond yield


Equity risk premium


a. Compute the price-to-earnings (P0 / E1) ratio for the industry based on this fundamental data.

b. Jones wants to analyze how fundamental P/E ratios might differ among countries. He gathered the following economic and market data:

Fundamental factors

Country A

Country B

Forecast growth in real GDP



Government bond yield



Equity risk premium



Determine whether each of these fundamental factors would cause P/E ratios to be generally higher for Country A or higher for Country B.

a. 30.0

b. (i) Yes (ii) Yes (iii) Yes

See the step by step solution

Step by Step Solution

Step 1: Calculation of estimated industry P/E ‘a’

gind =ROE X retention rate = 0.25 x 0.40 = 0.10

rind = government bond yield + ( industry beta x equity risk premium)

= 0.06 + (1.2 x 0.05)

= 0.12


P0/P1 = Payout ratio / r – g

= 0.60 / (0.12 – 0.10)

= 30.0

Step 2: Explanation on P/E ratios ‘b’

(i) Forecast growth in real GDP would cause P/E ratio to be higher for country A. This would imply higher earnings growth and a higher P/E

(ii) The higher P/E ratio for country B would be caused by government bond yield. A lower government bond yield would mean low risk free rate and higher P/E

(iii) The higher P/E ratio for country B would be caused by equity risk premium. A lower equity risk premium would mean lower required return and a higher P/E.

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