Div Discount Model & Justified leading P/E

Qbank #87941

A firm has the following characteristics:

  • Current share price $100
  • One-year earnings $3.50
  • One-year dividend $0.75
  • Required return 13%
  • Justified leading P/E 10

Based on the dividend discount model, what is the firm’s assumed growth rate?

So right away I saw DDM, P0, D1 and R, and went with the usual 100 = 0.75/(.13-g), solve for g, get 12.29%. But that’s not the answer, it’s actually 10.9%, based on this:

P0/E1 = (0.75/3.5) / (.13-g) = 10

g = 10.86%

Why do they do it that way, when my approach so explicitly fits the formula? I’m sure I’m missing something here/having a brain fart, but it’s killing me. I can’t figure it out, and qbank explanations are useless.

It says One year dividend (which i assume will mean dividend of the stock in the last reporting period), not Next year’s dividend.

One year Dividend will imply D0 -which given the way you have used it, will mean your model is not correctly specified.

PS. Hang on! it seems they’ve use one year earnings as E1 as well…??? well I’m lost here then!

Ok I took an independent study this semester for my master’s program, and got credit hours for studying for Level II. I had a professor who I met with once a week to update him on my studies and to ask questions. He writes questions for the Level II and III equity portions of the exams. He is also one of only 2 guys overseeing all the graders of level III essay questions. So he knows what he’s talking about.

I brought this question to him and had the same issues with it. He said the question was inconsistent and that either of those methods should work. He often had problems with the schweser questions I would bring to him. But we worked this problem out.

Bottom line… it’s a bad question with inconsistencies. On the exam, either of those method would work and get to the same answer.

The only thing I can think of is that a justified ratio is based on fundamentals, not the market price, so we can’t use the $100 to solve for g; ie. we’re trying to find the growth rate assumed in finding the justified ratio.

Am I at least on the right path here? Ugh, have so much review to do - but two weeks vacation starts friday :smiley: