Reading 56: An Introduction to Security Valuation- LOS d～ company, required, increase, decrease, discount

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Q25. All else equal, if a firm’s return on equity (ROE) increases, the stock’s value as estimated by the constant growth dividend discount model (DDM) will most likely:

A)   not change.

B)   decrease.

C)   increase.

 

Q26. Assume a company's ROE is 14% and the required return on equity is 13%. All else remaining equal, if there is a decrease in a firm’s retention rate, a stock’s value as estimated by the constant growth dividend discount model (DDM) will most likely:

A)   increase.

B)   either increase or decrease.

C)   decrease.

 

Q27. All else equal, an increase in a company’s growth rate will most likely cause its P/E ratio to:

A)   increase.

B)   decrease.

C)   either increase or decrease.

 

Q28. According to the earnings multiplier model, all else equal, as the dividend payout ratio on a stock increases, the:

A)   P/E ratio will decrease.

B)   P/E ratio will increase.

C)   required return on the stock will decrease.

 

yangh

 

Q25. All else equal, if a firm’s return on equity (ROE) increases, the stock’s value as estimated by the constant growth dividend discount model (DDM) will most likely: fficeffice" />

A)   not change.

B)   decrease.

C)   increase.

Correct answer is C)        

Increase in ROE: ROE is a component of g. As g increases, the spread between k_e and g, or the P/E denominator, will decrease, and the P/E ratio will increase.

 

Q26. Assume a company's ROE is 14% and the required return on equity is 13%. All else remaining equal, if there is a decrease in a firm’s retention rate, a stock’s value as estimated by the constant growth dividend discount model (DDM) will most likely:

A)   increase.

B)   either increase or decrease.

C)   decrease.

Correct answer is C)        

Increase in dividend payout/reduction in earnings retention. In this case, reduction in earnings retention will likely lower the P/E ratio. The logic is as follows: Because earnings retention impacts both the numerator (dividend payout) and denominator (g) of the P/E ratio, the impact of a change in earnings retention depends upon the relationship of k_e and ROE. If the company is earning a higher rate on new projects than the rate required by the market (ROE > k_e), investors will likely prefer that the company retain more earnings. Since an increase in the dividend payout would decrease earnings retention, the P/E ratio would fall, as investors will value the company lower if it retains a lower percentage of earnings.

 

Q27. All else equal, an increase in a company’s growth rate will most likely cause its P/E ratio to:

A)   increase.

B)   decrease.

C)   either increase or decrease.

Correct answer is A)

Increase in g: As g increases, the spread between k_e and g, or the P/E denominator, will decrease, and the P/E ratio will increase.

 

Q28. According to the earnings multiplier model, all else equal, as the dividend payout ratio on a stock increases, the:

A)   P/E ratio will decrease.

B)   P/E ratio will increase.

C)   required return on the stock will decrease.

Correct answer is B)

According to the earnings multiplier model, the P/E ratio is equal to P₀/E₁ = (D₁/E₁)/(k_e - g). As D₁/E₁ increases, P₀/E₁ will increase, all else equal.

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