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Synopsis

"GROWTH, Inc.’s next year earning is expected to be $4 per share. The company pays out half of its earning as dividend. Both dividends and earnings are expected to grow by 10% a year for the first 5 years, and grow by 5% a year indefinitely thereafter. STABLE, Inc. is like GROWTH in all respects except that its growth will stop after year 5. In year 6 and afterward, it will pay out all earnings as dividends. Both companies’ expected returns are 8%.
(a) What are the stock prices for each company?
(b) What are the P/E ratios and PEG ratios for each company? Assuming the average growth rates for GROWTH and STABLE are 6% and 3.33%, respectively.
(c) Which stock would you buy using the PEG rule? Now, suppose the stock prices computed in (a) are the actual traded prices. However, if you have assumed that both companies’ earnings will grow by 5% a year indefinitely in computing the fair values, which stock should you buy?
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