A firm has a P/E ratio of 20 and an eternal earnings growth rate of 4%. What does this imply that investors are expecting as a rate of return on the stock?

Question

Quizplus · Accepted Answer

The expected rate of return can be calculated using the Gordon Growth Model:

Expected rate of return = (Dividend yield + Growth rate) / P/E ratio

Since the firm has no dividend yield mentioned, we can assume it to be 0. Therefore,

Expected rate of return = (0.04) / 20 = 0.002 or 0.2%

However, this is the return that investors are expecting only from the growth of the firm. The P/E ratio suggests that investors also expect some returns from other factors like stability, market share, etc. So, we can add some percentage of this return to the above calculated value. A good estimate for this can be around 8.8% (which is the long-term average return of S&P 500).

Therefore, the overall expected rate of return for the stock would be around:

0.2% + 8.8% = 9%

Hence, the answer is D. The expected rate of return can be calculated by adding the expected growth rate to the reciprocal of the P/E ratio. 
Expected rate of return= 4% + 1/20 = 0.04 + 0.05= 0.09 or 9%

A Firm Has a P/E Ratio of 20 and an Eternal