say you have a nominal rate of return = 8% inflation = 3% the firm can only pass throught 40% of the inflation to earnings what’s the company’s P/E ratio?
Don’t forget it’s real rate of return in the denominator…
I get 15.03 Real rate: (1.08/1.03) - 1 = .048543689 P/E = 1/(.048543689 + (1-.4)*.03) = 15.03
Second guess 14.71, depends on if we are doing leading or trailing P/E, this one would be leading.
i just picked this off of one of my notecards so my guess is it comes from a schweser example in the text somewhere, but the formula is 1/required real rate of retun + (1 - inflation pass through) x inflation rate so here my notecard anyways uses 8% - 3% = 5% req rate of return (this is a bit of an approximation i’m sure) but basic idea anyways- 1/ .05 + .6(.03) = 14.705882 the higher the inflation flowthrough rate, the higher the P/E ratio. if you can’t pass through much of the inflation rate, it has more of a negative influence on stock price. random formulas. so many to know, yikes!
and this was p0/e1
You bet wrong bannisja…
damn I used nominal R
Bannisja, what LOS is this? I like the Q.
you can use nominal, I did, there is a different formula that mirrors the same result. Basically the difference would be in the denominator. With real rate denominator = [real r + (1-flow through)*inflation] With nominal rate denominator = [nominal r - (flow through*inflation)]
Swanny is a lock.
I’m only so good at this stuff because I suck at FSA and corp finance so badly I’ll read anything else to get out of reviewing those two.
to set the record straight, it would be more correct to use 1.08/1.03 to get the real rate of 4.85 like nibs said, right?
i agree with you, ng30. however, the difference should be minor. i don’t think CFAI will try to trick us.
It is not “more correct” the CFAi text offers both formulas and my answer came out correct to the thousandth of a decimal with what was posted by bannisja. If you look at both formulas, that I posted, they are algebraically equivalent, one uses real rate and adds the amount that doesn’t pass through while one uses nominal and subtracts the pass through. The result is the same exact denominator.