Given teh dividend payout ratio, CAPM and growth numbers, I do not get how the P/E ratio would be:
P/E = (Dividend Payout Ratio) / (CAPM - Growth)
How does the numerator relate to price and the denominator relate to earnings?
They don’t.
From Gordon growth:
P0 = D1 / (r − g)
P0 / E1 = [D1 / (r − g)] / E1
= (D1 / E1) / (r − g)
= (payout ratio) / (r − g)
Should we know this formula for the exam, or be able to use logic to derive it and other similar formulas?
I have not reached this part in the reading yet, just encountered it in practice questions…
It’ll show up again at Level II, so you should know it one way or the other.
I’d be happy to be able to derive it if needed.
Sure. Is there any way to explain this formula and the intuition behind it, or is this just algebraic derivation?
Starting from the Gordon Growth model - you get Price given the Dividends.
Dividing both sides by E (Earnings) - you get P/E ratio - which becomes D/E divided by the (r-g).
And D/E = Dividend payout…
So it is an extension of the GGM.
At Level II you’ll see all sorts of justified ratios: P/E, P/B, P/S, P/CF, and so on.
They all start from Gordon growth. CFA Institute is potty over Gordon growth.
Cool. So for level 1 what should I know regarding Gordon Growth and these price ratios?
everything … they tell you to know
As above. Just cover the LOS and you’ll be fine
Would this be the “justified” P/E? In addition, what does the word justified mean anyway in this context?
It is the justified P/E ratio.
“Justified” means consistent with (or derived from) the fundamentals of the company. As opposed to an actual (i.e., market) P/E ratio, which reflects what people (rationally or irrationally) are willing to pay for the stock.
Thanks for the answer!
You’re welcome.