A firm with a book value of $15.60 share and 100 percent dividend payout is expected to have a return on common equity of 15 percent per year indefinitely in the future. Its cost of equity is 10 percent.
a) Calculate the intrinsic price-to-book ratio
b) Suppose this firm announced that it was reducing its payout to 50 percent of earnings in the future. How would this affect your calculation of the price-to-book ratio?
a) A company's book value is really the value of its stockholders' equity section. The return on common equity is computed by dividing net income by stockholders' equity. Thus, if the book value per share is $15.60 and the return on common equity is .15, we can determine that:
.15=net income per share/$15.60
Given the firm's book value per share, cost of equity and return on equity, this solution illustrates how to compute its intrinsic price-to-book value ratio at two dividend payout ratios.