A firm has a payout ratio of 40%, a profit margin of 7%, an estimated growth rate of 10%, and its shareholders require a return of 14% on their investment. Based on these fundamentals, a reasonable estimate of the appropriate price-to-sales ratio for the firm (based on trailing sales) is:
Can someone explain why the (1+g) is required in this formula. I definitely understand the formula for a logic perspective, but why is the (1+g) required?
Thanks,
here’s a similar example-
Precision Tools is expected to have earnings per share (EPS) of $5.00 per share in five years, a dividend per share of $2.00, a cost of equity of 12%, and a long-term expected growth rate of 5%. What is the terminal trailing price-to-earnings (P/E) ratio in five years?
P5/E5 = (0.40 × 1.05) / (0.12 - 0.05) = 6.00
Why do we need the (1+g) piece here?
Using forecasted something means that the present value of future flows or values is on year 0.
If you use just current value (not using the 1+g), you will find the PV on year -1
All those formulas (derivations) are based on the Gordon Growth Model. You can demonstrate the model using the extended math of the present value of a stream of future values. You will get the same surely.
thnx!