THE ECONOMICS OF MONEY,BANKING, AND FINANCIAL MARKETS 176

144 PA R T I I APP LI CAT IO N Financial Markets Stock Valuation, Constant Growth To see how Equation works, let s compute the current market price of Coca-Cola stock, assuming dividends grow at a constant rate of 10.95%, D0 = $1.00, and the required return is 13% Solution P0 (1 D0 ke P0 $1.00 0.13 P0 $1.1095 0.0205 g) g (1.1095) 0.1095 $54.12 Coca-Cola stock should sell for $54.12 if the assumptions regarding the constant growth rate and required return are correct Price Earnings Valuation Method Theoretically, the best method of stock valuation is the dividend valuation approach Sometimes, however, it is difficult to apply If a firm is not paying dividends or has a very erratic growth rate, the results may not be satisfactory Other approaches to stock valuation are sometimes applied Among the more popular is the price earnings ratio The price earnings ratio (PE) is a widely watched measure of how much the market is willing to pay for $1 of earnings from a firm A high PE has two interpretations: A higher than average PE may mean that the market expects earnings to rise in the future This would return the PE to a more normal level A high PE may alternatively indicate that the market feels the firm s earnings are very low risk and is therefore willing to pay a premium for them The PE ratio can be used to estimate the value of a firm s stock Note that algebraically the product of the PE ratio times expected earnings is the firm s stock price P E E P (6) Firms in the same industry are expected to have similar PE ratios in the long run The value of a firm s stock can be found by multiplying the average industry PE times the expected earnings per share