 # Book7 1pm Q107

Here they say increase in retention ratio will INCREASE justified trailing P/E because growth rate goes up. “Increasing the retention rate would necessarily decrease the payout ratio. As the payout ratio decreases, the justified P/E increases due to a higher retention ratio. The higher retention ratio will lead to a higher growth rate.” my question: 1) Isn’t lower payout ratio = lower P/E (numerator)?

justified p/e ratio = ( 1 - b ) ( 1 +g ) / ( r - g ) with b = retention ratio and g = b * ROE justified p/e ratio = ( 1 - b ) ( 1 + b * ROE ) / ( r - b * ROE ) with b: 0

how are the book 7 exams? within reason or just way too many calculations like people have said about last year’s book 7

This isn’t a fair at all question! It depends - they should have given you ROE and K. P0/E1 = (1-b)*(1+ROE*b)/(K - ROE*b) Let’s allow ROE = .16, which is a very “typical” value for the SP500, and K=.12, which is also very typical. Here’s a table of values that I came up with: b= PE= 0 8.33 0.1 8.79 0.2 9.38 0.3 10.19 0.4 11.4 0.5 13.5 0.6 18.27 0.7 41.7 0.8 -28.2 0.9 -4.77 1 0 BTW, a b=80% is very reasonable, don’t you think?

i hope this won’t pop up in the real thing.