PE Ratio

CFA Level II Portfolio Management
#1

One of the problems in portfolio management is trying to explain why the PE ratio went from 16 to 18.4

The answer is 2 which I get why. However, why wouldn’t 3 be the answer as well? Because in theory when we decrease the earnings growth, the PE ratio goes up.

  1. Which of the following changes in market conditions best supports Carlisle’s comment regarding the equilibrium P/E for Country #3?
  2. A An increase in the equity risk premium
  3. B A decrease in uncertainty about future inflation
  4. C A decrease in expectation of future real earnings growth
#2

As an investor would you prefer to pay for a dollar of earnings that you expect to grow at a faster or slower rate in the future?

#3

What studyguy18 says is probably the easiest way to understand. However, if you wish to use formula logic then you may follow this,

In such cases, it’s always helpful to write P/E as

P/E = (1-b)x(1+g)/(r-g)

and decide the option will increase or decrease which component.

  1. Increase in Equity Risk Premium will increase denominator in the form of higher r… so P/E will decrease

  2. Decrease in uncertainty about future inflation should reduce the denominator in the form of lower r… so P/E will increase

  3. A decrease in expectation of future real earnings growth will reduce numerator in the form of lower g and increase numerator as lower g is deducted