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A simple example will help to solidify these ideas. Assume the smoothed earnings per share of a firm are $2.60 and this is all returned as dividends. Assume that this is expected to grow at 2 % and the required return on equity is 15%. Then what is the present value of this income stream? Simply the share price and this is calculated to be $20.
At $20 the Price/Earnings ratio is 7.7.