Stock Valuation and P/E Ratio [16 Points] The research analyst at Needham & Company believes that Tootsie Roll Industries has a return on equity (ROE) of 10.2% with a beta (β) of 0.30. Tootsie Roll Industries plans to maintain indefinitely its plowback ratio of 0.64. The firm’s earnings this year (E0) were equal to $1.12 per share. The research analyst estimates that the expected return this year for the market E(rm) will equal 14% and T-bills will offer a 4% return (rf = 4%).
(a) Find the price at which a share of Tootise Roll Industries should sell.
(b) Calculate the P/E ratio for Tootsie Roll Industries.
(c) Suppose the research analyst publishes a report stating that they believe that Tootsie Roll will soon lower its plowback ratio to 0.58. If you’re a current stockholder in Tootsie Roll should you purchase more stock or sell your position? Assume that the stock is currently trading at the value you found in Part (a). Explain your reasoning. [Hint: Earnings next year will change.]