Dividend discount model - Earnings multiplier

CFA Level I
#1

beta = 1.15

risk free rate = 5%

expected market rate of return = 12%

dividend payout ratio = 35%

expected dividend growth rate = 12%

Can someone explain to me how 33.3 would be the earnings multiplier when computed by the dividend discount method? I am confused on what should be in the numerator and the denominator.

Thanks!

#2

r = rf + beta * (rm -rf) = 0.05 + 1.15 ( 0.12 - 0.05 ) = 0.1305

p/e = earnings multiplier = (1-b)/(r-g) = (0.35)/(0.1305 - 0.12) = 0.35 / 0.0105 = 33.33

[Remember they gave you dividend payout ratio which is equal to (1-b) where b = retention ratio)

#3

But I do not get how the DDM would be equated to the earnings multiplier and the P/E ratio?

#4

DDM gives you

P0 = D1 / (r-g)

D1 = E1 * (1-b) [Earnings times dividend payout = Dividend)

So

P0 = E1 * (1-b) / (r-g)

So P0 / E1 = (1-b) / (r - g)

QED.

#5

Two words:

Gordon growth

#6

and you need to understand how the variables relate to each other.

Price, Earnings, Growth rate, Return on Equity, Dividend, Payout Ratio, Retention Ratio

You need to look at the equation of the GGM holistically, and be prepared to be given 3 out of the 4 variables and calculate the 4th. (P0 = D1 / (r-g)).

#7

Sounds good. Just doing some practice problems and did not reach this section in the readings yet, so I will defintely become more adept as I keep reading through the books!