Seen many contradictions on this: If required return = 10% inflation = 1% flow through = 100% is the P/E 10 or 11?
- If you flow through 100% of inflation then it has no effect on your earnings.
Btw, 1/r is the highest P/E you can achieve in this context so it would be impossible for the P/E to be greater than 10.
Its 11. You have to adjust the required return for inflation, so you will have 1/(.1-.01). Since its full flow through you wont have any additional adjustments.
Head in hands…
This depends on your given required return. If it’s real, P/E = 10. If it’s nominal, P/E = 11.2*
Yep, r has to be real r. So if given nominal r, you must subtract inflation rate to get real r.
The formula is 1/[(r-i)+(1-inflation flow through rate)*(inflation rate)] So plugging the formula: 1/(.10-.01)+(0*.01)---->1/.09 = 11.11
P/E = 1 / (nominal - (inflation flow through rate) x (inflation ) ) OR P/E = 1 / (real int + (1-inflation flow) x ( inflation)) if the question states real, then use the real. peace
How come sometimes we subtract inflation from nominal to get the real rate and sometimes we divide (1+ nominal) / (1 + inflation) = (1 + real)? Is subtracting just the approximation, if so would you ever get a question wrong for dividing?
P/E1 = 1 / (r - flow through*inflation) = 11.11
My question is when given the nominal rate and inflation do we always adjust for inflation by subtracting (the approximation)? In this case it is close 9% vs 8.91%, but would it ever make a difference between two answer choices on the test?
You want to use the real required rate of return, so just subtract out inflation. they do the same thing in derivatives where they use the linear approximation for currency appreciation/depreciation instead of using the exact calculation. Inflation in US 5% Inflation in UK 2% thus you expect UK to appreciate by 3% even though the exact calc is [1+rDC/1+rFC] - 1= [1.05/1.03] -1 = 2.94%