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Growth Rate in Residual Earnings Implied by P/E

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3. Lyons, Inc. earned $472 million in 2007 on a beginning book value of common equity of $2,200 million. The firm paid no dividends and had no stock transactions during 2007. The required return for its equity is 11%. At the end of 2007, its shares traded at a trailing P/E of 12.8.

A. What growth rate in future residual earnings is implied by this P/E ratio of 12.8
B. At this growth rate, what return on equity forecasted for 2008?

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Solution Summary

This post explains in step by step manner the concepts of valuation by solving a problem. The concepts discussed include growth rate in residual, ROE, relationship between P/E and residual earnings.

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a)
First, get residual earnings (RE) for 2007 and the book value at the end of 2007 for the residual earnings model.
RE for 2007 = Earnings - Book Value at the beginning*r=472-2200*11% = 230

Book value at the end of 2007= Book value at the beginning of 2007 + Earnings in year 2007 - dividends paid ...

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