honeycfa

Assuming that a company's return on equity (ROE) is 12% and the required rate of return is 10%, which of the following would most likely cause the company's P/E ratio to rise?

A) The inflation rate falls.

B) The firm's ROE falls.

C) The firm's dividend payout rises.

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• Decrease in the expected inflation rate. The expected inflation rate is a component of k_e (through the nominal risk free rate). k_e can be represented by the following: nominal risk free rate + stock risk premium, where nominal risk free rate = [(1 + real risk free rate)(1 + expected inflation rate)] – 1.

  • If the rate of inflation decreases, the nominal risk free rate will decrease.
  • k_e will decrease.
  • The spread between k_e and g, or the P/E denominator, will decrease.
  • P/E ratio will increase.

(An increase in the stock risk premium would have the opposite effect.)

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

• Increase in dividend payout/reduction in earnings retention. In this case, an increase in the dividend payout will likely decrease the P/E ratio because a decrease 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.

honeycfa

If the expected dividend payout ratio of a firm is expected to rise from 50 percent to 55 percent, the cost of equity is expected to increase from 10 percent to 11 percent, and the firm’s growth rate remains at 5 percent, what will happen to the firm’s price-to-equity (P/E) ratio? It will:

A) decline.

B) be unchanged.

C) increase.

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Payout increases from 50% to 55%, cost of equity increases from 10% to 11%, and dividend growth rate stays at 5%, the P/E will change from 10 to 9.16:

P/E = (D/E) / (k – g).

P/E₀ = 0.50 / (0.10 – 0.05) = 10.

P/E₁ = 0.55 / (0.11 – 0.05) = 9.16.

honeycfa

Which of the following is NOT a determinant of the expected price/earnings (P/E) ratio?

A) Expected dividend payout ratio (D/E).

B) Average debt to capital ratio (D/C).

C) Expected growth rate in dividends (g).

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The P/E ratio is determined by payout ratio D/E, required return K_e, and expected growth g.

honeycfa

According to the earnings multiplier model, which of the following factors is the least important in estimating a stock’s price-to-earnings ratio? The:

A) estimated required rate of return on the stock.

B) expected dividend payout ratio.

C) historical dividend payout ratio.

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P/E = (D₁/E₁)/(k - g)

where:
D₁/E₁ = the expected dividend payout ratio
k = estimated required rate of return on the stock
g =  expected growth rate of dividends for the stock

The P/E is most sensitive to movements in the denominator.

honeycfa

Use the following information to determine the value of River Gardens’ common stock:

• Expected dividend payout ratio is 45%.
• Expected dividend growth rate is 6.5%.
• River Gardens’ required return is 12.4%.
• Expected earnings per share next year are $3.25.

A) $24.80.

B) $30.12.

C) $27.25.

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First, estimate the price to earnings (P/E) ratio as: (0.45) / (0.124 – 0.065) = 7.63. Then, multiply the expected earnings by the estimated P/E ratio: ($3.25)(7.63) = $24.80.

honeycfa

All of the following factors affects the firm’s P/E ratio EXCEPT:

A) the required rate of return.

B) growth rates of dividends.

C) the expected interest rate on the bonds of the firm.

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The factors that affect the P/E ratio are the same factors that affect the value of a firm in the infinite growth dividend discount model. The expected interest rate on the bonds is not a significant factor affecting the P/E ratio.

honeycfa

Assuming all other factors remain unchanged, which of the following would most likely lead to a decrease in the market P/E ratio?

A) A decline in the risk-free rate.

B) A rise in the stock risk premium.

C) An increase in the dividend payout ratio.

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P/E = (1 - RR)/(k - g)

To lower P/E: RR increases, g decreases and or k increases. Both a decline in the RF rate and a decline in the rate of inflation will reduce k. An increase in the stock's risk premium will increase k.

honeycfa

A stock has a required return of 14% percent, a constant growth rate of 5% and a retention rate of 60%. The firm’s P/E ratio should be:

A) 6.66.

B) 4.44.

C) 5.55.

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P/E = (1 - RR) / (k - g) = 0.4 / (0.14 - 0.05) = 4.44

honeycfa

If the expected dividend payout ratio of a firm is expected to rise from 50 percent to 55 percent, the cost of equity is expected to increase from 10 percent to 11 percent, and the firm’s growth rate remains at 5 percent, what will happen to the firm’s price-to-equity (P/E) ratio? It will:

A) decline.

B) be unchanged.

C) increase.

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Payout increases from 50% to 55%, cost of equity increases from 10% to 11%, and dividend growth rate stays at 5%, the P/E will change from 10 to 9.16:

P/E = (D/E) / (k – g).

P/E₀ = 0.50 / (0.10 – 0.05) = 10.

P/E₁ = 0.55 / (0.11 – 0.05) = 9.16.

honeycfa

If the payout ratio increases, the P/E multiple will:

A) decrease, if we assume that the growth rate remains constant.

B) always increase.

C) increase, if we assume that the growth rate remains constant.

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When payout ratio increases, the P/E multiple increases only if we assume that the growth rate will not change as a result.