THE ECONOMICS OF MONEY,BANKING, AND FINANCIAL MARKETS 176

144

PA R T I I

APP LI CAT IO N

Financial Markets

Stock Valuation, Constant Growth
To see how Equation 5 works, let s compute the current market price of Coca-Cola
stock, assuming dividends grow at a constant rate of 10.95%, D0 = $1.00, and the
required return is 13%.

Solution

P0

(1

D0
ke

P0

$1.00
0.13

P0

$1.1095
0.0205

g)
g
(1.1095)
0.1095
$54.12

Coca-Cola stock should sell for $54.12 if the assumptions regarding the constant growth rate and required return are correct.

Price Earnings
Valuation
Method

Theoretically, the best method of stock valuation is the dividend valuation approach.
Sometimes, however, it is difficult to apply. If a firm is not paying dividends or has
a very erratic growth rate, the results may not be satisfactory. Other approaches
to stock valuation are sometimes applied. Among the more popular is the price
earnings ratio.
The price earnings ratio (PE) is a widely watched measure of how much
the market is willing to pay for $1 of earnings from a firm. A high PE has two
interpretations:
1. A higher than average PE may mean that the market expects earnings to rise
in the future. This would return the PE to a more normal level.
2. A high PE may alternatively indicate that the market feels the firm s earnings
are very low risk and is therefore willing to pay a premium for them.
The PE ratio can be used to estimate the value of a firm s stock. Note that
algebraically the product of the PE ratio times expected earnings is the firm s
stock price.
P
E

E

P

(6)

Firms in the same industry are expected to have similar PE ratios in the long
run. The value of a firm s stock can be found by multiplying the average industry
PE times the expected earnings per share.