Found this question: Assuming all other variable remain unchanged, which of the following would increase a firm’s P/E ratio? A. The level of inflation is expected to decline B. The yield on T-Bills increases C. Investors become more risk averse D. The dividend payout ratio decreases The provided answer is… D But, I don’t get it: based on P/E = (D/E)/k-g a dividend payout ratio decrease means a decrease in (D/E) and also an increase in g (as g = Retention Ratio (now bigger) X ROE So you have a smaller denominator and a smaller numerator…right? so why would your P/E ratio increase? Thanks
Dividend payout ratio decreases if company is a growth company. That means more part of it Earning is going to increase revenue rather than paying out dividend. For Growth company , actually we can’t apply D/k-g as Price of the stocks as there is a possibility of no or variable Dividend pay out which is not increasing at constant rate. So please do not consider P/E=(D/E)/(k-g) equation in mind to understand relationship between D and P
what equation is D/E /k-g? Infation increase may reduce the P/E depending on the company’s passthrough capability Increase in Treasury yields should increase the costs of equity and thus reduce the P/E ratio If investors become risk averse, it means they buy more of fixed income securities, and sell shares, thus reducing the P/E ratios If the divident payout ratio increases, it means your payout ratio is higher and the P/E ratio also increases. remember P = Div1/(k-g) which is P= (EPS* Payout ratio)/(k-g) and therefore we divide both sides by EPS to get the P/E ratio which is P/E = Payout Ratio/(k-g) Hope my two cents helps.
Short answer: Whether a decrease in the dividend payout ratio is expected to increase P/E depends on the relationship between a firm’s cost of capital (k) and its ROE. D is the only reasonable answer, but in order for it to be correct, the firm’s ROE > k. Long answer: http://www.analystforum.com/phorums/read.php?11,644874,644982#msg-644982
Well it must be just a rubbish question. Point 1 - The payout ratio can’t change without affecting the retention ratio Point 2 - A decrease in the payout ratio (ignoring Point 1) will result in a lower PE, not higgher as asked for in the question.
The denominator will be much smaller on a percentage basis, so PE increases.