Hi - quick question, for the justified p/e formula adapted from the dividend discount model (p/e = (d/e) / (r-g) ), what is the effect on p/e from raising the payout ratio?
if you raise the payout, retention is lower and hence g is lower (RR * ROE) if g gets lower, value of the stock gets lower
But what about the numerator effect. Assuming you raise the payout ratio, you have a higher numerator over a higher denominator. From plugging in a few different numbers, it appears that the answer changes depending on the levels of the inputs used.
In this case - denominator effect will dominate the numerator effect and hence the P/E reduces.
Remember P/E’s are driven by growth expectations. Therefore, if the payout ratio increases, long term sustainanble decreases and hence, the P/E decreases.
I understand the logic behind p/e decreasing as more is paid out in dividends, but consider the calculation below: Example 1: Dividends 1, earnings 2, D/E 0.5, Req ret 15%, ROE 10%, g 5% Justified p/e 5 Dividends 1.5, earnings 2, D/E 0.75, Req ret 15%, ROE 10%, g 3% Justified p/e 6 Example 2: Dividends 1, earnings 2, D/E 0.5, Req ret 8%, ROE 10%, g 5% Justified p/e 16.67 Dividends 1.5, earnings 2, D/E 0.75, Req ret 8%, ROE 10%, g 3% Justified p/e 13.64 It seems the effect on P/E depends on the required return used - any thoughts?
It seems like its not always the case. So if you increase your dividend payout by 50% (which is huge), PE increases. Thanks for pointing that. I would say always do the calculation and check whether it is increasing or decreasing. If they ask you in theory, then P/E decreases as 50% growth increase in div payout is abnormal.
edit
“All else being equal, justified P/E’s are: 1. Positively related to the growth rates of future cash flows 2. INVERSELY RELATED TO THE REQUIRED RATE OF RETURN.” Stalla notes!!
El Matarife Wrote: ------------------------------------------------------- > “All else being equal, justified P/E’s are: > > 1. Positively related to the growth rates of > future cash flows > 2. INVERSELY RELATED TO THE REQUIRED RATE OF > RETURN.” > > > Stalla notes!! yeah but check those problems which OP posted. Growth decreased but still P/E increased hence negative relation in few cases.
less retension, less growth, since Dividend growth model is measuring the present value of long term dividend performance, it makes sense for P/E to drop
How about this? Assume no dividends, so b=1, and P/E = 0/r = 0 If you increase the payout from zero to anything else, b <1, so P/E > 0. Thus, by increasing the payout ratio, P/E increased.
Hmm interesting, a P/E doesn’t make economic sense. Also, I don’t think you can use DDM if your payout ratio is 0.
It seems that when the required rate > ROE, a higher payout results in a higher PE. This is probably because the company is not earning enough to compensate its equity investors, thus it’s more risky, leading to a higher P/E?
I would think P/E decreases if required > ROE. P/E = 1/r + FF * G where FF = (1/r - 1/ROE), so if r > ROE, FF is negative, lowering the overall P/E. Qualitatively, if a firm cannot take on projects that earn more than equity investors require, that is seen as a bad sign, and in turn, its price should fall (negative outlook usually drops the price of a stock, as investors feel that the company isn’t doing a good job in completing projects that reward investors for risks). As a result of price falling, P/E falls as well.
But hold on a second. g = ROE*b b is less or equal to 1 k has to be bigger than g or you could say ROE can’t be larger than k otherwise, you can’t apply P/E = (D1/E1) / (k - g)
If the franchise factor is negative, then it’s non-existent, I would think. Franchice factor is kind of like the companies competitive advantage. It’s the companies ability to grow earnings about and beyond the required rate of return. I see how this differs from Gordon Growth model as I’ve posted above… In GGM, we need long-run returns which wouldn’t make sense if we keep growing above the required returns in the P/E = 1/r + FF*G which some value investors apply, you only have perpetual earnings unless the company has a competitive advantage. Otherwise FF*G is 0 and not negative. Am I off here?
hey guys - please stop formula bashing - r > ROE means company is “on its way out”. Not having enough projects to go over the hurdle rate of Return on Equity. This is simply (zimbly) not sustainable.
Companies can have negative P/E’s, even though it is rendered meaningless. Not sure why FF would have a floor value of 0. My reasoning that allows FF to be 0 is that investors will face an opportunity cost if the firm took on a project that returned less than the required return, so investors would punish the company by selling the stock. Aliman, this becomes a question of whether a firm could be worth less than its perpetual earnings stream without any growth. I believe it can (FF can be < 0) because investors will treat the project that failed to return more than required as if it were a “loss”, which may cause some uncertainty about whether the perpetual earnings can suffice. This is purely theoretical of course, and I’m more of a numbers guy, so I’d be surprised to see why there is a floor of 0 for FF.