Q3
Given the information on Exhibit 2, Current P/E: 15.6 & Expected P/E 10 years prior: 15
Why is the change in PE calculated as (15/15.6)^.1 -1 rather than (15.6/15)^.1 -1
The Institute lost me there as well.
maybe because it’s current vs forecast. i also thought 15.6/15 but seeing the answer as it is 10-year trailing pe maybe that’s what we shud use as LT p/e
Just keep in mind that a higher current P/E than expected refers to a negative repricing yield.
Hence you should know which one to use as numerator/denominator…
S2000 Magician, can you help?
Here is the data
Exhibit 2: Current and Expected Market Statistics, US Large-Cap Equities
Expected dividend yield 2.1%
Expected inflation rate 2.3%
Expected repurchase yield 1%
Current P/E 15.6
Expected real earnings growth 2.6%
Expected P/E 10 years prior 15
Using the data in Exhibit 2 and Fiske’s preferred approach, the estimated expected annual return for US large-cap equities over the next 10 years is closest to:
A. 7.9%.
B. 7.6%.
C. 7.4%.
Answer = B
“Capital Market Expectations,” John P. Calverley, Alan M. Meder, Brian D. Singer, and Renato Staub Section 3.1.2.1
The Grinold–Kroner model formula is
E® = D/P ‒ Δ_S_ + i + g + Δ_PE_.
First, compute the compound annual growth rate of the P/E: (15.0/15.6) 1/10 – 1 = ‒0.4%.
Next, compute, as a percentage, the expected return per the Grinold–Kroner model formula:
The prior figure can be assumed to be a long term average, and the current figure can therefore be assumed to reprice to the long term average over another 10 years.
As a result, the annual repricing figure is the annual compounded return required to return to the long-term average. Also to note, calculating the return with 0 for a P/E repricing return, or the non-compounded P/E reversion to long term return (-3.85%) produces values that are not among the available answers.
“a higher current P/E than expected refers to a negative repricing yield.” that’s insightful but why is that…Thanks!
Lets say you own stock A, which is currently priced at $100 and has $10 in earnings for a P/E ratio of 10 (100/10).
If you project the future P/E to contract to 9 (meaning your current P/E is higher), and assuming no change in earnings, you will incurr a negative return. A P/E ratio of 9 with $10 in earnings translates into a price of $90. If you owned it at $100 and now its worth $90. You had a negative return of 10%.
This makes no sense. I think the CFAI goofed on this one. Why on earth would a higher PE than expected be a negative return?