Reading 44: U.S. Portfolio Strategy: Seeking Value—Anato

valuation, discount, expected, maintain, function

LOS d: Indicate the impact of discount rate sensitivity in valuation models.

Q1. At a CFA society function, Robert Chan comments to Li Chiao that the expected dividend growth rate for Xanedu Industries has decreased 0.5% from 6.0% to 5.5%. Chan claims that since Xanedu will maintain their historic dividend payout ratio (g) of 40% and cost of equity (k) of 12%. Xanedu's P/E ratio will also decrease by 0.5%. Is Chan correct?

A) Yes, Xanedu's P/E ratio will increase by approximately 0.5%.

B) No, Xanedu's P/E ratio will decrease by approximately 7.8%.

C) No, Xanedu's P/E ratio will increase by approximately 7.8%.

Q2. At a CFA society function, Andrew Caza comments to Nanda Dhople that the expected dividend growth rate (g) for Zeron Enterprises Inc (ZEI) is expected increase 0.5% from 6% to 6.5%. Caza claims that since ZEI will maintain their historic dividend payout ratio (g) of 50% and cost of equity (k) of 10%, ZEI's P/E ratio will also increase by 0.5%. Is Caza correct?

A) No, ZEI's P/E ratio will decrease by approximately 14.32%.

B) Yes, ZEI's P/E ratio will increase by approximately 0.5%.

C) No, ZEI's P/E ratio will increase by approximately 14.32%.

Q3. For which of the following firms is the Price/Earnings to Growth (PEG) ratio most appropriate for identifying undervalued or overvalued equities?

Firm A: Expected dividend growth = 6%; Cost of equity = 12%; price-to-earnings (P/E) = 12.
Firm B: Expected dividend growth = ?6%; Cost of equity = 12%; price-to-earnings (P/E) = 12.
Firm C: Expected dividend growth = 1%; Cost of equity = 12%; price-to-earnings (P/E) = 12.

A) Firm C.

B) Firm B.

C) Firm A.

[2009] Session 12 - Reading 44: U.S. Portfolio Strategy: Seeking Value—Anato

LOS d: Indicate the impact of discount rate sensitivity in valuation models. fficeffice" />

A) Yes, Xanedu's P/E ratio will increase by approximately 0.5%.

B) No, Xanedu's P/E ratio will decrease by approximately 7.8%.

C) No, Xanedu's P/E ratio will increase by approximately 7.8%.

Correct answer is B)

Chan is not correct. P/E_Xanedu = payout ratio / (k - g)
When the expected dividend growth is 6%, P/E = 0.40 / (0.12 - 0.06) = 6.67
When the expected dividend growth is 5.5%, P/E = 0.40 / (0.12 - 0.055) = 6.15
The percentage change is (6.15 / 6.67) - 1 = -7.80%, representing a 7.80% decrease

A) No, ZEI's P/E ratio will decrease by approximately 14.32%.

B) Yes, ZEI's P/E ratio will increase by approximately 0.5%.

C) No, ZEI's P/E ratio will increase by approximately 14.32%.

Correct answer is C)

Caza is not correct. P/E_ZEI = payout ratio / (k - g)
When the expected dividend growth is 6%, P/E = 0.50 / (0.10 - 0.06) = 12.50
When the expected dividend growth is 6.5%, P/E = 0.50 / (0.10 - 0.065) = 14.29
The percentage change is (14.29 / 12.50) - 1 = 14.32%, representing a 14.32% increase

Q3. For which of the following firms is the Price/Earnings to Growth (PEG) ratio most appropriate for identifying undervalued or overvalued equities?

A) Firm C.

B) Firm B.

C) Firm A.

Correct answer is C)

The formula for the PEG ratio is: PEG = (P/E) / g. It measures the tradeoff between P/E and expected dividend growth (g). For traditional growth firms, PEG ratios fall between 1 and 2. The general rule is that PEG ratios above 2 are indicative of overvalued firms (expensive), and PEG ratios below 1 are indicative of firms that are undervalued (cheap).

Firm A:	PEG = 2, indicating a stock that is appropriately priced.
Firm B:	The PEG ratio of firms with negative expected dividend growth is negative, which is meaningless. For Firm B, PEG = -2.
Firm C:	Firms with very low expected dividend growth are likely to have PEG ratios that unrealistically indicate overvalued stocks. For Firm C, PEG = 12.