JonnyKay

The following data was available for Morris, Inc., for the year ending December 31, 2001:

• Sales per share = $150.
• Earnings per share = $1.75.
• Return on Equity (ROE) = 16%.
• Required rate of return = 12%.

If the expected growth rate in dividends and earning is 4%, what will the appropriate price-to-sales (P/S) multiple be for Morris?

A) 0.037.

B) 0.114.

C) 0.109.

---

Profit Margin = EPS / Sales per share = 1.75 / 150 = 0.01167 or 1.167%.
Payout ratio = 1 − (g / ROE) = 1 − (0.04 / 0.16) = 0.75 or 75%.
P0 / S0 = [profit margin × payout ratio × (1 + g)] / (r − g) = [0.01167 × 0.75 × 1.04] / (0.12 − 0.04) = 0.11375.

JonnyKay

An analyst has gathered the following data about the Garber Company:

• Payout Ratio = 60%.
• Expected Return on Equity = 16.75%.
• Required rate of return = 12.5%.

What will be the appropriate price-to-book value (PBV) ratio for the Garber Company based on return differential?

A) 0.58.

B) 1.38.

C) 1.73.

---

The estimated growth rate is 6.7% [0.1675 × (1 − 0.60)] and PBV ratio based on rate differential will be:
P0 / BV0 = (ROE1 − g) / (r − g) = (0.1675 − 0.067) / (0.125 − 0.067) = 1.73.

JonnyKay

What is the justified leading price-to-earnings (P/E) multiple of a stock that has a retention ratio of 60% if the shareholders require a return of 16% on their investment and the expected growth rate in dividends is 6%?

A) 4.00.

B) 6.36.

C) 4.24.

---

P0/E1 = 0.40 / (0.16 – 0.06) = 4.00

JonnyKay

An increase in which of the following variables will least likley result in a corresponding increase in the price-to-book value (PBV) ratio for a high-growth firm?

A) Required rate of return

B) Payout ratios.

C) Growth rates in earnings.

---

The PBV ratio decreases as the required rate of return increases.

JonnyKay

All other variables held constant, the justified price-to-book multiple will decrease with a decrease in:

A) expected growth rate.

B) payout ratio.

C) required rate of return.

---

All other variables held constant, a decrease in expected growth rate will result in a decrease in the justified price-to-book multiple.

JonnyKay

A decrease in the earnings retention rate will cause a price-to-sales (P/S) multiple to:

A) decrease.

B) remain the same.

C) increase.

---

A decrease in the earnings retention rate will increase the following expression for P/S due to the implied increase in the payout ratio, which is (1 – b):

P0 / S0 = [(E0 / S0)(1 – b)(1 + g)] / (r – g)

Note that the topic review does not allow for any interactive relationship between retention and growth. Thus, no explicit consideration is given to whether the increase in the payout ratio will cause an offsetting decrease in growth.

JonnyKay

An increase in growth will cause a price to cash flow multiple to:

A) decrease.

B) there is insufficient information to tell.

C) increase.

---

An increase in growth increases the price to cash flow ratio (CF), as indicated by the following expression:

P0 / CF0 = (1 + g) / (r – g)

JonnyKay

An increase in growth will cause a price-to-earnings (P/E) multiple to:

A) there is insufficient information to tell.

B) decrease.

C) increase.

---

An increase in growth will decrease the denominator and increase the numerator in the trailing P/E expression, both of which should increase the P/E ratio:

P0/E0 = [(1 – b)(1 + g)] / (r – g)

Note that the topic review does not allow for any interactive relationship between retention and growth. Thus, no explicit consideration is given to how the growth increase was generated.

JonnyKay

An increase in financial leverage will cause the trailing price-to-earnings (P/E) multiple to:

A) decrease.

B) increase.

C) there is insufficient information to tell.

---

An increase in financial leverage will cause the required rate of return to increase, thereby decreasing the P/E. This is clear in the expression for trailing P/E:

P0 / E0 = [(1 – b)(1 + g)] / (r – g)

(Note: the topic review does not allow for any interactive relationship between leverage, return on equity (ROE), and growth. Thus, no explicit consideration is given to whether the increase in leverage would increase ROE and therefore growth through the g = (ROE × retention) relationship

JonnyKay

The net impact of an increase in payout ratio on price-to-book value (PBV) ratio cannot be determined because it might also:

A) decrease the market value of the firm.

B) decrease expected growth.

C) decrease required rate of return.

---

If payout increases, the growth of the firm may slow down, because internally generated funds are not being invested in new, profitable projects. Hence, the net impact on the PBV ratio from change in payout ratio cannot be determined.