a tricky question on P/E DDM his, performing, question, expected, required

bpdulog

Hi
A quastion from Schweser: Tim Jan, CFA, relies on the earning multiploer model in performing his fundamental analysis. His model is based on the constant growth DDM. Jan is evaluating two stocks, A and B, that have the same 10% required rate of return and the same expected growth rate in dividends. Stock A has a higher retention rate than stock B. which stock should have higher P/E ratio?
the answer from Shweser: Because k – g is the same for both stocks, the stock with the highest payout rate (D1/E1) has the highest P/E. The stock with the lowest retention rate (and highest payout rate) is Stock B.
BUT my question is that kg can not be the same for both stocks, because when stock A has a higher retention rate then it will have a higher g since g = RR * ROE. So due to that we can not give any comment on P/E of which stock will go up or down (since the changing in retention rate will effects both numerator and denominatur). Am I right? how do you see this?

Maddin

If A has a lower ROE, it can surely have a g that equals B.
If the info is given, just answer the question they ask. k and g are equal per the question so focus on the varying factor…the payout ratio.
thats they way i appraoched it.

Sunshine4ever

You’re over thinking it. They already told you the denominator was fixed, so you have to accept that as fact. The rest is common sense…the higher the D/E ratio is, the highe ther P/E ratio.

NakedPuts

There is no mention that ROE is the same, so one company does not have to have a higher g than the other. Ex g=0.4=0.8*0.5 or g=0.4=0.6*0.66. Same g, different RR and ROE.