ART company has come out with a new and improved product. As a result, the marke
ID: 2735457 • Letter: A
Question
ART company has come out with a new and improved product. As a result, the market projects an ROE of 25% for the company, and we know the company will maintain a plowback ratio of 0.20. The company's earnings this year is $3 per share and the current market price is $35. If firms with similar risks in the industry have a PE ratio of 20 with an estimated earnings growth rate of 12%, is ART company overvalued or undervalued based on PEG approach?
A.
The ART company is overvalued because it has a PEG ratio that equals to 1.42
B.
The ART company is undervalued because it has a PE ratio that equals to 11.11
C.
The ART company is overvalued because it has a PE ratio that equals to 22.15
D.
The ART company is undervalued because it has a PEG ratio that equals to 1.42
E.
The ART company is overvalued because it has a PEG ratio that equals to 2.22
F.
The ART company is undervalued because it has a PEG ratio that equals to 2.22
Please Explain.
A.
The ART company is overvalued because it has a PEG ratio that equals to 1.42
B.
The ART company is undervalued because it has a PE ratio that equals to 11.11
C.
The ART company is overvalued because it has a PE ratio that equals to 22.15
D.
The ART company is undervalued because it has a PEG ratio that equals to 1.42
E.
The ART company is overvalued because it has a PEG ratio that equals to 2.22
F.
The ART company is undervalued because it has a PEG ratio that equals to 2.22
Explanation / Answer
Calculation of growth rate of ART:
Growth rate is computed by multiplying the ROE and plowback ratio.
Growth rate = 25% X 0.20 = 0.05 or 5.00%
Dividends for next year = $3.00 (1+0.05) = $3.15
Po = $35.00
Accordign to Dividend growth model,
Cost of equity = (Dividend per share / Current price) + growth rate
= ($3.15 / $35.00) + 0.05
= 0.14 or 14.00%
PE ratio of ART = $35.00 / 3.00 = 11.67 times
Hence, ART company undervalued based on PEG approach.
Therefore, oprtion B is correct.