Once again the earnings per share forecast will depend on the sales and profit margin forecasts.
Estimate sales, look at the company's sales performance with respect to its industry and the economy, as well as factors that will influence the individual company's ability to increase sales e.g. potential to expand capacity.
Estimate the company's profit margin, look at the firm's performance relative to the industry environment, its competitive position, and general company trends.
Estimating a company's earnings multiplier
Two methods can be used to calculate the earnings multiplier:
1. Use microanalysis to estimate the P/E by looking at the economy and its industry.
2. Calculate the three components of the earnings multiplier; the dividend payout ratio, the required rate of return and growth rate.
One way to make an investment decision is to buy a stock that is trading below its intrinsic value and to sell a stock trading above its intrinsic value. Another approach is to use the intrinsic value to calculate the expected rate of return assuming the market price migrates to the intrinsic value, and add the stock dividend. This can be compared to the investor’s required rate of return.
The expected rate of return is given by:
E (Rt) = (IV - BV + Div)/ BV
E (Rt) = expected rate of return during period t
IV = estimated intrinsic value of the stock
BV = beginning value of the stock (or current market price)
Div = expected dividend per share during the holding period
Stock is trading at a market price of $42.00 and an analyst uses discounted cash flow analysis to estimate an intrinsic value of $45.00. The expected dividend per share is $3.50 over the period. Calculate the expected rate of return.
(45.00 – 42.00 + 3.50)/42.00 = 15.5%
If an investor's required rate of return is higher than 15.5% over this period, they should sell the stock; if it is lower they should buy the stock.
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