Question 3

An analyst is valuing ABC plc, a listed company whose shares are currently trading at the price £6.21 per share. This company has maintained a dividend pay-out ratio of 60% earnings for a number years and tends to keep doing this for the coming years. 

The analyst has estimated a risk free rate of 5% and a market risk premium 7%. The beta of ABC plc is estimated at 1.2. Companies in the industry that ABC plc is operating have the average price to earnings ratio of 10 times. The earnings history of ABC is as follows:

Year Earnings

Last reported       68p

One year ago       65p

Two years ago     64p

The rate of growth in earnings and dividends shown in the past is expected to continue into the future.

Required:

a) Calculate the current price-earnings ratio and the growth rate of earnings.

b) Using the P/E ratio and the Dividend growth model, estimate the fair value of the ABC plc’s shares.

c) Based on the results, discuss if the company is overvalued or undervalued and what the investors should do?

d) Discuss the following statements: “If debt is available companies should attempt to become as highly geared as possible”.