P. 379 on Schweser Book 4 Equity Investment Self Test: Question 6 “Allied Aviation Financial Infor: ROE: 10.75% Cost of equity capital: 9.25% Retention ratio: 75% Other Financial Infor: S&P 500 Index P/E: 24 S&P 500 expected growth rate: 5% S&P 500 divident yeild: 2.85% Q: suppose that during his initial evaluation of Allied stock, Reilly estimated that Allied’s implied PE was 37. Later on, he increased his extimated growth rate for the S&P 500 to 6.5%. All else being equal, the increase in the S&P 500 estimated growth rate implies that Allied’s implied PE ratio should be: A. less than 37 B. greater than 37 C. unchanged, because growth in the index is not a component of implied PE D. unchanged, because actual market factors remain unchanged. Answer: A. the implied PE for Allied and the index growth rate are negatively related, all else being equal.” Shouldn’t PE and growth rate be positively related?? then PE ratio becomes greater than 37? What does “implied” mean in this case? Any help is greatly appreciated!!
Please shed some light!
The way I read this is: Gordon Growth Model method of calculating equity risk premium is one year forecast index dividend yield plus expected growth rate less LT govt bond yield. Therefore since index growth rate increases, ERP increases. This leads to increased cost of equity capital using CAPM. Using P/E equation: P/E = (1-b) (1+g) / r - g if r increases P/E decreases.