Suppose that the consensus forecast of security analysts of Pegasus Inc. is that earnings next year will be E₁ = $12.00 per share. The company tends to plow back 30% of its earnings and pay the rest as dividends. The CFO estimates that the company's growth rate will be 8% from now on.
(a) If your estimate of the company's required rate of return is 10%, what is the equilibrium price of the stock?
(b) You observe that the stock is selling for $350.00 per share. Suppose you believe that the market price is right. What must you conclude about either (i) your estimate of the stock's required rate of return, (ii) the CFO's estimate of the company's future growth rate, or (iii) the forecast of earnings from the analysts?
(c) Suppose there is uncertainty about the stock's growth rate. With 30% probability the growth rate will be 9% and with 70% probability the growth rate will be 4%. What are the respective market values under the two different rates of return?
(d) What is the fair price of the stock given the probabilities previously listed?
