If the payout ratio increases, the P/E multiple will: A) always increase. B) increase, if we assume that the growth rate remains constant. C) always decrease. D) decrease, if we assume that the growth rate remains constant.
Answer is B, but how can we assume that “g” remains constant when technically is Dividend Payout Ratio increases, g will go down since retention ratio goes down? Are they assuming ROE goes up?
A. I have seen one similar.
Are they assuming ROE goes up? They must be. The dividend would increase in the numerator, and the denominator would stay the same, thus increasing the valuation of the equity.
Schweser begs to differ… “When payout ratio increases, the P/E multiple increases only if we assume that the growth rate will not change as a result.” B.
I got it now, I guess we could assume the P/E will rise IF the growth rate does not change. If the growth rate changes, we cannot conclude anything.
But if Dividend Pay out increases, wont Retained Earnings go down and lower ROE too? Hence g HAS to go down…
G = ROE*(1-Payout) Therefore, if G stays the same, ROE must increase in order for the equation to balance. IF the P/E were to rise, then this MUST be true. If G is not constant, we cannot conclude what the P/E will do with a larger payout.
I see man. Cheers.
FYI: “Because earnings retention impacts both the numerator (dividend payout) and denominator (g) of the P/E ratio, the impact of a change in earnings retention depends upon the relationship of ke and ROE. If the company is earning a higher rate on new projects than the rate required by the market (ROE > ke), investors will likely prefer that the company retain more earnings. Since an increase in the dividend payout would decrease earnings retention, the P/E ratio would fall, as investors will value the company lower if it retains a lower percentage of earnings.” So, if keROE and Dividend Payout increases, P/E goes up?