The value of a common stock is based on the present value of the future cash flows that will accrue to that stock. Of course, the present value calculation necessarily involves the use of a required rate of return (a discount rate), which reflects the risk. The textbook indicates that “To some extent, the two concepts of P/E ratios and dividend valuation models can be brought together. A stock that has a high required rate of return (Ke) because it is risky will generally have a low P/E ratio. Similarly, a stock with a low required rate of return (Ke) because of the predictability of positive future performance will normally have a high P/E ratio” (Block et al, p. 322). In this discussion, you will examine the relationship between a stock’s required rate of return and its P/E ratio.
Select a publicly traded company that pays dividends. You may select any publicly traded company that pays dividends, or choose one of the companies discussed in Best Dividend Stocks for Dependable Dividend Growth.
Determine the most recent stock price and the total dividends paid over the past year.
Calculate the current dividend yield on the stock.
Calculate the required rate of return (Ke) for an investment in the common stock. You should use formula 10-9 in the textbook (SEE PICS) for this calculation and use an assumed growth rate of 5 percent.
Identify the current P/E ratio for the company from a source such as Yahoo! Finance or Barron’s.
In your post,
Show your calculations of the dividend yield and required rate of return (Ke) and present the P/E ratio.
Explain the relationship between your chosen company’s Ke and P/E ratio and what that relationship indicates about the risk of the company’s future cash flows.
Explain whether the general relationship between a high Ke and a low P/E ratio (or low Ke and high P/E ratio) is supported by the data for your chosen publicly traded company.
Predict the impact on the company’s stock price based on your forecast that the company will grow its dividends by a rate higher than 5%.
Compare your company’s P/E ratio with the P/E ratios of two other companies in its industry.
Hypothesize which company in this industry should have the lowest Ke based on the P/E comparisons.
Summarize the connection between a company’s growth rate, its required rate of return, and its value (stock price).
A. Calculation of Current Dividend Yield
The Dividend Yield is the annual dividend divided by the current stock price.
Dividend Yield=P0D0Dividend Yield=$60.00$1.80=0.030 or 3.0%
B. Calculation of Required Rate of Return (Ke)
The required rate of return (Ke) is calculated using the Gordon Growth Model (Formula 10-9: P0=Ke−gD1), which we rearrange to solve for Ke. Note that D1=D0(1+g).
Ke=P0D1+g
Calculate Next Year's Expected Dividend (D1):
- D1=D0(1+g)=$1.80(1+0.05)=$1.89
Calculate Required Rate of Return (Ke):
- Ke=$60.00$1.89+0.05Ke=0.0315+0.05=0.0815 or 8.15%
The Required Rate of Return (Ke) for The Coca-Cola Company is 8.15%.
II. Relationship Between Ke and P/E Ratio
A. Analysis of Ke and P/E for KO
Required Rate of Return (Ke): 8.15%
P/E Ratio: 25.00
The required rate of return (Ke) reflects the risk associated with the stock; a lower Ke suggests lower perceived risk and high certainty of future cash flows. The P/E ratio reflects investor expectations of future growth and profitability—a high P/E suggests investors are willing to pay more for each dollar of current earnings, anticipating strong growth.
For KO, a low Ke (8.15%) paired with a relatively high P/E ratio (25.00) indicates that:
Risk Certainty: Investors perceive Coca-Cola's future cash flows (dividends and earnings) as highly predictable and low-risk due to its stable industry position, global scale, and strong brand moat. This certainty results in the low required rate of return.
Growth Expectation: The high P/E ratio (above a typical market average of 15−20) suggests that investors still expect consistent, dependable growth in earnings, justifying the high price multiple.
B. Support for the General Ke and P/E Relationship
The data supports the general relationship cited from the textbook, which states that a low Ke (due to predictability) is normally associated with a high P/E ratio. Coca-Cola is a classic example of a blue-chip, defensive stock where the stability (low risk/low Ke) is the primary factor allowing investors to assign a premium multiple (high P/E).
C. Impact on Stock Price from Higher Growth Forecast
If I forecast that Coca-Cola will grow its dividends at a rate higher than 5% (e.g., 6%), the stock price is predicted to increase significantly, assuming the Ke remains unchanged.
Using the Gordon Growth Model with the new g=6.0% and the original Ke=8.15%:
Sample Answer
This analysis requires selecting a publicly traded dividend-paying company and performing calculations based on a specific formula (Formula 10-9, the Gordon Growth Model). Since I cannot access external stock data in real-time or the specific textbook image, I will proceed by selecting a well-known, dividend-paying company and using hypothetical, but realistic, data to demonstrate the required calculations and analysis.
Selected Company: The Coca-Cola Company (KO)
I. Stock Data and Calculations (Hypothetical Data)
| Metric | Hypothetical Value | Source |
| Most Recent Stock Price (P0) | $60.00 | Yahoo! Finance (Hypothetical) |
| Total Dividends Paid Last Year (D0) | $1.80 | Annual Report (Hypothetical) |
| Current P/E Ratio | 25.00 | Yahoo! Finance (Hypothetical) |
| Assumed Dividend Growth Rate (g) | 5.0% | Given in Prompt |
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