All else equal, the P/E ratio of a stable firm will increase if the: A. ROE is increased B. Dividend payout is increased C. Required rate of return is increased D. Long-term growth rate is decreased Correct answer is A, and I understand why A works. It is clear C&D are incorrect. Can someone please explain why B is incorrect? Isn’t is true: P/E = Dividend Payout / (k-g) ? Thanks
What you are saying is true. However, when the dividend payout is increased, you must also take into consideration the effects of the decline in the growth rate. Since growth rate = retention ratio x ROE, an increase in the dividend payout will decrease the retention ratio, thus decreasing the growth rate and “g” in the equation. I believe in most cases, the decrease in “g” outweighs the increase in the payout ratio, which decreases the P/E ratio.
Mr. Clean - That makes sense. Thanks
Did a little research on this… A general rule of thumb, if ROE > k… P/E ratio will likely decrease when retention rate decreases. The logic is: if the company projects are generating higher returns than the market rate requires, retain the earnings and reinvest. No mention of the ROE to k relationship in this question though… oh well