Question #55
Reading: Reading 20 Discounted Dividend Valuation
PDF File: Reading 20 Discounted Dividend Valuation.pdf
Page: 22
Status: Incorrect
Correct Answer: A
Your Answer: B
Question
Heather Callaway, CFA, is concerned about the accuracy of her valuation of Crimson Gate, a fast-growing telecommunications-equipment company that her firm rates as a top buy. Crimson currently trades at $134 per share, and Callaway has put together the following information about the stock: Most recent dividend per share $0.55 Growth rate, next 2 years 30% Growth rate, after 2 years 12% Trailing P/E 25.6 Financial leverage 3.4 Sales $1198 per share Asset turnover 11.2 Estimated market rate of return 13.2% Callaway's employer, Bates Investments, likes to use a company's sustainable growth rate as a key input to obtaining the required rate of return for the company's stock. Crimson's sustainable growth rate is closest to:
Answer Choices:
A. 14.8%
B. 16.6%
C. 13.2%
Explanation
Sustainable growth rate = ROE × retention rate
Earnings per share = price / (P/E) = $134 / 25.6 = $5.23
The retention rate represents the portion of earnings not paid out in dividends. = (5.23 −
0.55) / 5.23 = 0.89 or 89%
ROE = profit margin × asset turnover × financial leverage
ROE = 5.23 / 1198 × 11.2 × 3.4 = 16.6%
Sustainable growth rate = 89% × 16.6% = 14.8%