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CA Final · Advanced Financial Management · Security Analysis

Tara Foods Ltd has a constant dividend payout of 50%, expected growth of 8% and cost of equity of 14%. The stock trades at Rs 90 with next-year EPS of Rs 12. Using the justified forward P/E from the constant growth model, which conclusion follows?

The justified forward P/E is 8.33, implying a value of Rs 100 against the market price of Rs 90, so the stock is undervalued. It comes from payout 50% divided by cost of equity 14% less growth 8%.

  1. AJustified P/E is 8.33; the stock is undervalued at a P/E of 7.5Correct
  2. BJustified P/E is 8.33; the stock is overvalued at a P/E of 7.5
  3. CJustified P/E is 7.14; the stock is undervalued at a P/E of 7.5
  4. DJustified P/E is 8.33; the stock is fairly valued at a P/E of 7.5

Explanation

Justified P/E = payout/(ke - g) = 0.5/0.06 = 8.33. Justified price = 8.33 x 12 = Rs 100. Market price Rs 90 (P/E 7.5) is below Rs 100, so undervalued. Overvalued reverses the comparison.

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