high PE ratio = less risky firm?

In Corp Finance Schweez, and example they give for determining whether or not the implementation of a dividend policy would affect the PE results in utilization of the “Leading PE ratio” in order to view how the dividend policy would impact PE. In the example, the PE from the leading PE ratio is 14 and the original PE was 10. Schweser says that investors will now perceive the firm as less risky due to a higher PE ratio. I always thought lower PE ratios were a better value. Why would they say that a higher PE ratio is a less riskier firm?

higher return - lower risk?

It’s an interesting question. I was talking to a colleague after one of our value managers (PHD, very well known quant guy) mentioned that he didn’t see how anyone could make money on growth stocks over the long term. I can see how it makes sense - investing in value companies means investing in shi**y companies, or else why would the prices be so low? Hence, these low P/E value companies are in fact riskier. Disclosure - none of the above is based on CFA readings, just some thoughts/discussion over some offhanded comments, so take it for what it’s worth.

think in today’s terms. Most financial companies today, like banks, have low P/E’s, and are considered risky, whereas high P/E firms, like Google, are a safer name. You can also think about it this way - if a stock seems risky, its price could fall to 0. That means your numerator goes to 0, which shows that the lower the P/E is, the more risky it is.

Well i think its not necessarily IF the PE ratio is higher or lower… but rather WHY it is higher or lower that indicates whether or not it is riskier. If PE high, is it because: High price? Low Earnings? Growth rate implications? and vice versa for when the PE is low So unless we know the inputs into the PE, I don’t think you can actually say whether or not one PE is riskier than the other. I think you can make assumptions. But without knowing the inputs, a blanket statement cannot be made. Right?

^ mathematically, that makes sense, however, you should also expect that when earnings are expected to go down, then price follows, so the P/E ratio adjusts accordingly to reflect those risks.

High PE ratio = more risky firm. After June 6, you can argue otherwise.

I think the key here is the " implementation of a dividend policy". They are arguing that according to bird in the hand theory, that investors view dividend paying companies as “safer” investments (atleast in the USA). Thus, with safer investment, the required return for equity decreases - P/E = D/R-G. If R decreases, the PE ratio increases. Does that make sense?

G above also decreases if you pay higher dividend and not retain enough for growth.

Dreary Wrote: ------------------------------------------------------- > G above also decreases if you pay higher dividend > and not retain enough for growth. Yeah, true: G = ROE * Retention ratio. Retention ratio decreases with dividend payment.

I’m surprised Schwser would say that… Do you have a pg. number for us? In anycase, it depends on the market. There isn’t a (correct) rule here. Perhaps we could argue guidelines, but even then…

Chi Paul Wrote: ------------------------------------------------------- > It’s an interesting question. > > I was talking to a colleague after one of our > value managers (PHD, very well known quant guy) > mentioned that he didn’t see how anyone could make > money on growth stocks over the long term. I can > see how it makes sense - investing in value > companies means investing in shi**y companies, or > else why would the prices be so low? Hence, these > low P/E value companies are in fact riskier. > > Disclosure - none of the above is based on CFA > readings, just some thoughts/discussion over some > offhanded comments, so take it for what it’s > worth. No this is in CFA in the price multiples section, where a low P/E is justified because the company is inherently crappier…

A little late to the party here, but it sounds to me that they are saying the firm is perceived to be less risky because it is now paying a dividend. Therefore, investors have a lower required return and hence PE is higher (because r-g will be smaller). Pretty certain I have had a few practice q’s that ask you to calculate this exact relationship.

P/E = (1-b) / (r-g) The riskier the firm the higher the R and the lower the P/E

Also if a firm is risky why would investors pay a premium for the stock? Riskier firms should trade at a discount hence lower P/E

versus the value investing idea that companies that are ‘perceived’ to be risky trade at lower P/Es but are not actually as risky as the market assumes them to be…

Well, the standard deviation of growth indices is larger than their value counterparts over the long term. This gap has been closed recently, but I would bet that is almost exclusively driven by the extreme volatility of the financials that make up a good chunk of the value benchmarks. Of course, you could argue that the tech bubble is what drives the volatility in the 10 year standard deviations… I’m waffling, I know, so I think there really is no definitive answer, but if I got a q like that on the exam, I think I would take MT’s quant approach.

FYI I just came accross this in the text: CFAI Volume 4, Reading 27 Page 315 “Why is the quality of earnings important? One reason is that companies with high earnings quality are considered less risky because these firms have “banked” earnings using conservative accounting policies.” and “High-quality earnings should be accorded a higher price/earnings multiple (all other things being equal) than low-quality earnings. The higher multiple reflects the lower risk as well as the understatement of reported income.” Not sure if this ends this debate… but its good enough for a right exam question should it arise.

… and by volume 4, I mean volume 2 :slight_smile:

P/E is just a factual number, based on company’s earnings and price. P/E stand alone can not tell you whether the company is high risk or low risk. A high P/E can easily hide stuff in off balance sheet and could very well become risky. A low P/E could very easily hide stuff in off balance sheet financing and could very well become risky.