SECTION B 80 MARKS here are FIVE 5 questions in this section

SECTION B: 80 MARKS here are FIVE (5) questions in this section. Choose ANY FOUR (4) questions. Each question carries 20 marks. QUESTION 1: P/E RATIO One of the most common valuation tools that uses earnings in its valuation of securities is the price/earnings ratio (PIE ratio). This ratio is published and used by a number of financial analysts and fund managers and its use has been increasing overtime. Required a) You have been told of two companies; Kondwani Financial Limited and Deal Breakers Limited. Kondwani Financial Limited has a P/E Ratio of 15 while Deal Breakers Limited has a P/E ratio of 8. Explain the concept of P/E ratio (also referred to as earnings multiplier) and how P/E multiple can be used in the stock valuation process and stock price behaviour. i. (6 marks) i. Between the two companies Kondwani and Deal Breakers, based on their P/E ratio, which company would you recommend as having a superior P/E ratio. For ful marks, clearly state your assumptions justifying your choice of company 4 marks) ili. Explain the impact of stock risk on P/E ratios (2 marks) b) Kokoliko PLC has maintained a constant dividend pay-out ratio over the last 5 years and intends to continue with the same ratio into the future. Last year EPS was K80 and K32 was paid out as dividends while the P/E ratio was 8. Kokoliko has a standard deviation of 4% and a beta of 1.3. Over the coming year, the following are expected ROE of 15% Return on Government securities of 7% LuSE index return of 12% Required i. Compute the expected growth rate in internal earnings i. Compute the market price of Kokoliko\'s shares last year ili. Based on the expected values, compute the intrinsic value of Kokoliko\'s share and (2 marks) (2 marks) determine if the shares are over-valued or undervalued given a market price of K50 today (4 marks) Total: 20 marks

Solution

1. a) i) Concept of Price Earning Ratio: The price earnings ratio (P/E Ratio) is a valuation method used to compare a company\'s current share price to its per-share earnings.

It is a ratio that gives investors a better sense of the value of the company. The P/E ratio shows the expectations of the market and is the price you must pay per unit of current earnings or future earnings. A high P/E could indicate that a stock\'s price is high relative to earning and low P/E could indicate that a stock\'s price is low relative to earning.

However, Companies that grow faster will have higher P/E Ratio. A higher P/E ratio shows that the investors are willing to pay higher share price since the company\'s growth expectation in future. A high P/E ratio does not mean that the stock is overvalued.

Earnings are important when valuing a company\'s stock because investors want to know how profitable a company is and how profitable it will be in the future.

ii) The Kondwani Financial Limited\'s share price may be higher due to its higher P/E Ratio. It does not mean it\'s overvalued. The risk and reward may be higher as compared to the Deal Breakers. Since Deal Breakers\' PE Ratio is low, it\'s share price may be low and the return also will be lower.

iii) Impact of stock risk on P/E Ratio

The price earning ratio is one of the most used tool while investing by investors.

High price earnings ratios have been followed by slow long run growth in stock prices.

b) i) Expected growth rate in internal earnings

g = b x r

where g= growth, b= retention ratio and r = return on investment

b= DPS/EPS = K32/K80 = .40 or 40%

g = 0.40 x 0.15= 0.06

ii)Expected Vaule of Market price of Kokoliko\'s share

P/E Ratio = 8

K_{e ⁼} Risk Free return + (beta x Market Risk Premium)

=7% + (1.3 x (12%-7%)

= 7% + 6.5%

= 13.5%

Price = D_{0 /} Ke - g

= 32 (1+0.06) / 0.135 -0.06

= 33.92 /0.075

=452.27