 # Tough P/E question

Assuming that a company’s return on equity (ROE) is 12% and the required rate of return is 10%, which of the following would most likely cause the company’s P/E ratio to rise? A) The firm’s dividend payout rises. B) The firm’s ROE falls. C) The inflation rate falls. D) The stock risk premium rises.

Opss… it is D. Rm= Rf + b(Rm-Rf)

A.

it is A… P/E = (D1/E) / (k-g) where: g = retention rate x ROE D1/E = dividend payout ratio so if the firm’s dividend payout ratio rises, its P/E ratio will rise due to the positive relation between them.

…only trouble is that since dividend payout is part of g, you have dividend payout in both numerator and denominator! For example, if dividend payout ratio rises to 1.0 (you pay all earnings as dividends), then P/E = 1/k which may not always be HIGHER than say: P/E = 0.50/(k-0.50*ROE) So, in general, yes, the answer is A.

I think the answer is C because I remember reading that the biggest determinant of P/E ration is the relationship between k and g. If the inflation rate falls, then K goes down, which shrinks the denominator, and makes the P/E ration higher… what’s the answer?

B is false D is false A is right C is right >>> it has the most effect on P/E

Yeah I’d go with C A is wrong imo … : if the dividend payout rises , rate of retention is REDUCED g = rate of retention X ROE therefore : “g” is reduced… k-g INCREASES, the price[=d1/k-g] FALLS, P/E ratio declines…

C – if inflation falls, required return will go down and increase P/E A-- can not be right, as ROE > Required rate of return, and investors will like the firm to increase retained earnings (i.e., decrease Dividend payout)

edit: oops, lower inflation not higher, answer is ‘C’

> A) The firm’s dividend payout rises. P/E decreases because shareholders would be better off reinvesting -> incorrect > B) The firm’s ROE falls. P/E decreases -> incorrect > C) The inflation rate falls. required return decreases -> P/E increases -> correct > D) The stock risk premium rises. required return increases -> P/E decreases -> incorrect C is the answer

Lower inflation = multiple expansion. The answer is C

The answer would be A if k > ROE, not in this case, but just watchout this can become a tricky question. Say k=13%, and Div Payout=0.60, then P/E = 0.60/(k-(0.40)*0.12) = 7.32 Now increase Div Payout=0.70, then P/E = 0.70/(k-(0.30)*0.12) = 7.44 (P/E increased in this case).

A is not right, because if dividend increase, growth rate will decrease. Thus the effects cancel each other out. SO the correct answer is C.

Yes, but note what i wrote above.

Dreary, you are correct!

Not to mention small changes b/t k and g cause large changes in price. Just thought I would throw that gem in there.

“Not to mention small changes b/t k and g cause large changes in price. Just thought I would throw that gem in there.” AGREED – that is why a small change in terminal value assumptions (when doing a DCF, you use the gordon growth model to get the firm’s value beyond your projected period) can really change your price target on a stock. This is technically not on L1, but worth thinking about. Thus, most analysts do SENSITIVITY analyses.

I will go with A coz This will affect Numerator(Increase) and denominator(Decrease) as well. But C Inflation will affect only denominator(decrease). So Option A makes more sensible to me. Cheers Abhi

Abhi, the answer is C.