Price-to-earnings (P/E) ratio of a stable firm will increase if...

CFA Level I Equities
#1

I had a question on this practice question I came across yesterday:

All else equal, the price-to-earnings (P/E) ratio of a stable firm will increase if the:

A) Dividend payout is decreased

B) ROE is increased

C) Long term growth rate is decreased

The correct answer is B. While I understand that C is definitely not the right answer, why can’t the answer also be A? As I recall an increasing long term growth rate (“g”) will increase P/E, so if g=ROE*(1-b) with “b” being the dividend payout ratio, won’t “g” increase if I decrease “b”? I appreciate the help guys.

#2

Take a look at this article I wrote on justified ratios (for Level II, but it’s applicable here): http://financialexamhelp123.com/justified-ratios-price-multiples/. As the payout ratio goes down, P/E goes down.

#3

I agree with B.

P/E = DPR/(r-g)

If DPR goes down, the numerator makes PE go down.

If DPR goes down,RR goes up - hence g goes up (RR*ROE) and the denominator makes PE go up.

There is a tradeoff between g and DPR (alternative A). Since DPR changes affect both the numerator and the denominator in different directions, P/E may go up or down.

The relationship between ROE and g is direct (alternative B).

So alternative B will increase the PE ratio. Alternative A may increase it, but may also decrease it.

#4

Can I say that option A is also known as " dividends displacement of earnings" ?

Thank You.

#5

Makes perfect sense now. Thank you!