problem: GROWTH, Inc.’s next year earning is expected to be 4 dollar per share. The company pays out half of its earning as dividend. Both dividends & earnings are expected to grow by 10 percent a year for the first five years, and grow by 5 percent a year indefinitely thereafter. STABLE, Inc. is like GROWTH in all respects except that its growth will stop after 5 year. In year 6 & afterward, it will pay out all earnings as dividends. Both companies’ expected returns are 8 percent.
[A] Determine the stock prices for each company?
[B] Determine the P/E ratios and PEG ratios for each company? Suppose the average growth rates for GROWTH and STABLE are 6 percent and 3.33 percent, respectively.
[C] Which stock would you buy using the PEG rule? Now, suppose the stock prices computed in [A] are the actual traded prices. However, if you have assumed that both companies’ earnings will grow by five percent a year indefinitely in computing the fair values, which stock should you buy?