The question is : All else equal, the price-to-earnings (P/E) ratio of a stable firm will increase if the: A) dividend payout is decreased. B) required rate of return is increased. C) ROE is increased. D) long-term growth rate is decreased. Don’t you think both A and C could increase the value of P/E? Reasoning: P/E = (D/E)/(r-g) Any increase in g will result in an increase in P/E. Since growth rate is a function of retention rate(RR) and ROE, an increase in either of them should increase the value of g. g = RR*ROE = (1-divident payout ratio) * ROE I am not sure why C is chosen as the answer. Does the term “stable firm” means that the company won’t change the payout ratio? Comments please
kochunni69, retaining a higher portion of earnings won’t increase P/E unless the return generated by reinvesting those earnings are in excess of the company’s cost of capital. However, the increase in ROE, all else equal, should increase P/E. We’ve had some thorough discussion around the special relationship between k and ROE in determining how changes in the payout (or retention) ratios are likely to affect P/E. Specifically, I suggest reading through these two threads (links below): http://www.analystforum.com/phorums/read.php?11,644874 http://www.analystforum.com/phorums/read.php?11,635886,635886#msg-635886 Hopefully these threads will clarify things for you, but don’t hesitate to ask for additional explanations if you still have questions. Cheers.
This is exactly the point made in the Schweser Secret Sauce is Stupid thread below about P/E ratios and dividend payouts. “Stable firm” means that you can reasonably say that the growth rate continues until forever.
All else equal, the price-to-earnings (P/E) ratio of a stable firm will increase if the: A) dividend payout is decreased. This will increase or decrease the P/E depending of the sign of ROE-k… B) required rate of return is increased. Will allways decrease the PE ratio. C) ROE is increased. Will allways increase the PE ratio. D) long-term growth rate is decreased. Depends whether the growth rate decreases because the ROE decreases or because the retention ratio decreases… So the easy answer is C). Hope this helps. Marc
Thanks mhannebert…make perfect sense. hiredguns1, thank you for sharing those intelligent posts
mhannebert, I didn’t get the explanation of P/E depending on the sign of ROE-k for option A? Can you pls elaborate? Thanks.
I see your point. I didn’t realize it when I agree to the previous posting. P/E is meaningless if ROE is -ve