A firm has a P/E ratio of 14, and investors are expecting a 10% return on the stock. What does this imply they expect the firm's eternal earnings growth rate to be?

Question

Quizplus · Accepted Answer

The P/E ratio and the expected return can be related through the formula: Expected Return = (Dividend Payout Ratio / P/E Ratio) + Growth Rate. Assuming the dividend payout and retention ratios are constant, and given that the P/E ratio is 14 with an expected return of 10%, we can rearrange the Gordon Growth Model (which is a part of the dividend discount model for a perpetually growing dividend) to solve for the growth rate. The formula simplifies to Expected Return = (1 / P/E Ratio) + Growth Rate, implying that the growth rate is the expected return minus the earnings yield (which is the inverse of the P/E ratio). Thus, 10% - (1/14) = 10% - 7.1% = 2.9%.

A Firm Has a P/E Ratio of 14, and Investors