Johnson and Johnson, a leading manufacturer of health care products, had a return on equity of 31.5% in 1993 and paid out 37% of its earnings as dividends. The stock had a beta of 1.25. (The treasury bond rate is 6%.) The extraordinary growth is expected to last for ten years, after which the growth rate is expected to drop to 6% and the return on equity to 15%. (The beta will move to 1.)
a. Assuming the return on equity and dividend payout ratio continue at current levels for the high growth period, estimate the PBV ratio for Johnson and Johnson.
b. If health care reform passes, it is believed that Johnson and Johnson”s return on equity will drop to 20% for the high growth phase. If they choose to maintain their existing dividend payout ratio, estimate the new PBV ratio for Johnson and Johnson.
(You can assume that the inputs for the steady state period are unaffected.)