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Unformatted text preview: rate investment, if those investments add value
to the firm.
i.e: ROE >K
ROE =(Profit Margin)(Asset Turnover)(A/ E leverage) Example:
An industry analysis reveals that firms have been paying
out 55% of their earnings in dividends, asset turnover = 2;
Asset-to-equity = 2 and profit margins are 17%. What is
the industry’s projected growth rate?
First we need to find ROE:
ROE = profit margin x asset turnover x A/E =
= 0.17 x 2 x 2 = .68
g = ROE x b = 0.68 x 0.45 = 31%
ROE Commonly Used Price Multiples
Price to earnings (P/E)
Price to book value (P/BV)
Price to sales (P/S) Earnings Multiplier Model (P/E Ratio)
To convert the dividend discount model to an
earnings multiplier model -Divide both sides of
the DDM by E1 and we have:
P0/E1 = (D1/E1) / (k – g)
Use expected P/E, not trailing The difference between k and g drives the P/E
i.e: the smaller the difference, the higher the P/E
Any variables that influence stock prices in the
DDM will have the same impact on the P/E ratio.
The P/E ratio is inversely related to changes in the
market capitalization rate.
Growth stock have high P/E ratios. Value stocks have low P/E ratios.
When P/E increases, ROE increases because high ROE
implies the firm has good opportunity for growth.
Riskier stocks will have lower P/E multiples, because k
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