Which of the following factors would most likely reduce a company’s P/E ratio? A) short-term Treasury yield declines B) The company materially lowers its financial leverage C) The company increases its long-term ROE D) The inflation level is expected to increase to double-digits ok, obviously A and C are wrong, but why is D more right than B? I think both B) and D) would lower the P/E. With B), ROE and therefore g go down, with D) k increases, which also lowers P/E. Any ideas?

I like B better than D. B: as financial leverage gets lower, equity level gets higher, so P/E gets lower., D: P should increase with inflation, so it should increase P/E

Not sure why you think P increases with inflation. Are you referring to the price of the stock? What happens with inflation is RFR in CAPM goes up (remember the RFR in CAPM is nominal, not real), so k goes up, therefore P/E goes down

Good question, B & D are pretty close. I guess an increase in inflation directly impacts Ke, while a decrease in ROE impacts g only by the retention ratio…my 2 cents

lola, i think d is right through CAPM. risk free rate goes up, Ke goes up, denominator is higher, p/e is lower. lower leverage usually means lower earnings per share through higher equity. just my $.02

I did a similar problem. Here is the explanation: The expected inflation rate is a component of ke (through the nominal risk-free rate). ke can be represented by the following: nominal risk-free rate + stock risk premium, where nominal risk-free rate = [(1 + real risk-free rate) * (1 + expected inflation rate)] – 1. If the rate of inflation increase, the nominal risk-free rate will increase, ke will increase. The spread between ke and g, or the P/E denominator, will increase. P/E ratio will decrease.

delhi, good point, but I doubt the difference is quantifiable and I don’t think that’s what they’re getting at with this question. The more I think about it, the more it seems like a crappy question.

no doubt D is right, but Siberian_Golfer, good point. Didn’t think of the impact on EPS.

this is my 50 cent i disagree with singlesong because we are talking about efects prior to the increase in inflation so we shouldn’t go that far now for me D is obviously true because an ‘expected’ increase in inflation would change expected return before anything else changes for B - they say about reducing leverage but don’t mention anything about new equity- that would mean that they just pay off some debt. that would decrease assets and increase asset turnover creating an offset - this might be a stretch

B is correct if g decreases, then both the numerator, D1/E1 and denominator decrease, but regardless P/E will still decrease. Let g decrease by a factor of c. Compare the effect with g versus cg. P/E=(D0*g/E)/(k-g) so you need a situation where D0*cg/E/(k-cg)>D0*g/E/(k-g) where 0(k-cg)/(k-g), ck-cg>k-cg, ck>k, c>1 the premise is destroyed therefore it can’t happen

what’s the answer lola?

Dimes, very elegant. I wouldn’t have thought of that. Small correction (but the answer is still the same): " so you need a situation where D0*cg/E/(k-cg)>D0*g/E/(k-g) where 0 [D0*(1+g)/E] / k-g where 0 c>1 (same contradiction as you arrived to). Dime’s suggestion seems to work – what’s the answer lola?

I would believe that D is the answer to this question, because an increase in inflation will increase k making the denominator in the PE formula larger. Subsequently, a rise in PE

the answer is D