Select your language

Suggested languages for you:
Log In Start studying!
Answers without the blur. Just sign up for free and you're in → Illustration

Q3CP

Expert-verified
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

40%

Forecast industry returns on equity

25%

Industry beta

1.2

Government bond yield

6%

Equity risk premium

5%

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

5%

2%

Government bond yield

10%

6%

Equity risk premium

5%

4%

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

Therefore

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.

Most popular questions for Business-studies Textbooks

Icon

Want to see more solutions like these?

Sign up for free to discover our expert answers
Get Started - It’s free

Recommended explanations on Business-studies Textbooks

94% of StudySmarter users get better grades.

Sign up for free
94% of StudySmarter users get better grades.