Yet another Book 7 Question- DDM and P/E

According to Book 7, the P/E ratio will decline if the dividend payout ratio declines, which makes sense, since it is the numerator in the equation (D1/E1)/(k-g), however, if the dividend payout ratio decreases, doesn’t g increase, which would cause the opposite effect? Also, the Schweser notes say that the P/E formula is simply a rearrangement of the DDM (which is apparent), and as such, the same changes should have the same effect on both, however, if the dividend payout ratio decreases, shouldn’t D1/(k-g) increase? If so, these would be conflicting… I hate book 7

plug some numbers in and work it out using some different payout ratios and growth rates, derived from a constant earnings and ROE. It has to do with mathematical differences. ie., say EPS=3, ROE=.18, try figuring it out using payout ratios of 40% and then 20%.

Skrillin, You gotta love Book 7. I believe the contradiction you are seeing is due to the fact that when the ROE of a company is above its required rate of return, increasing Div Payout will LOWER the share price. You investors would rather you reinvest your earnings into the company because you are able to earn returns above the required rate. The opposite is true if your ROE is less than the required rate. In this case your price would go up if you increased Div Payout.

^ thats the key…took me a while to get that, but after I did…all P/E questions are a peice of cake…