Assuming that a company’s ROE is 12% and the required rate of return is 10%, which of the following would most likely cause the company’s P/E ratio to rise? A) The inflation rate falls. B) The firm’s dividend payout rises. C) The firm’s ROE falls. D) The stock risk premium rises.
A? Inflation falls --> RFR falls --> k declines P/E = [D/E] / (k-g) should increase.
B? if dividend payout increases the ddm creates a higher value if inflation falls that means that interest rates are likely to be higher that means that R will decrease but G as well
I am a little torn between A and B for A Infl falls, rce falls, so (rce-g) shrinks – so P/e = k / (rce - g) would increase. k = Dividend Payout increases. P/E would increase due to two effects k numerator increases. g decreases. because g = (roe) ( RR) = roe ( 1 - k) bcos k increased, g decreases so rce -g would increase so in this case - we have the numerator increasing, denominator also increasing. So I guess we cannot say which way the ratio will move. Given in the first case - it is always an increase – A would be the right answer.
I originally thought B, but it is A. Delhirocks explained it well. If the dividend payout rises, the retention rate goes down. That decreases growth (g=(roe)(rr)), which will make (k-g) larger.
i remember reading about this so went to the source… From CFAI book Vol 5 (Eq and FI) pg 138… the spread between k and g is the main determinant of the size of the P/E ratio. Although the div payout ratio has an impact, we are generally referring to a firm’s long run target payout, which is typically rather stable will little effect on yr to yr change in the P/E ratio (earnings multiplier). so basically, closing the bap between k and g will increase the P/E ratio.
If Dividend payout increases, Numerator will surely go up, by the g in the equation will decrease. this decline in g will have a more substantial negative impact on the stock price. take this for an example Dividend (last ) $1 ROE = 20% Dividend payout = 50% RFR = 5% Expected return = 15% beta = 1.25 ===Base-Scenario==================== g = 20% * (1-50%) = 10% K = 5% + 1.25*(15%-5%) = 17.5% D1 = 1*1.10 - $1.10 Period 1 earnings = $1.1/50% = $2.20 —> Price = 1.1 / (17.5% - 10%) = $14.67 P/E = 14.67 / 2.2 = 6.67—> Base case P/E ===Scenario-1==================== Dividend payout increases to 75% g = 20% * (1-75%) = 5% K = unchanged at 17.5% D1 = (1/0.5*0.75)*1.05 = 1.575 Period 1 earnings = 1.575/75% = $2.10 Price = 1.575 / 17.5% - 5% = $12.60 P/E = 12.60 / (1.575/75%) = 6.0 ===Scenario-2====================== Inflation decreases by 1% --> RF decreases by approximately 1% to 4%, expected return decreases by approximately1% to 14% g = unchanged at 10% (Base D1 = unchanged at $1.10 K = 4% + 1.25(14%-4%) = 16.5% Price = 1.1 / (16.5% - 10%) = $16.92 P/E = 16.92/2.20 = 7.69 =================================
Excellent explanation delhirocks. Bravo.