- CFA Exams
- CFA Level I Exam
- Study Session 11. Equity Valuation (3)
- Reading 29. Market-Based Valuation: Price and Enterprise Value Multiples
- Subject 3. Price to earnings: valuation based on forecasted fundamentals

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**CFA Practice Question**

The trailing P/E ratio will decrease if the ______ increases.

II. earnings retention ratio

III. required rate of return

IV. earnings growth rate

I. dividend payout ratio

II. earnings retention ratio

III. required rate of return

IV. earnings growth rate

A. I and III

B. II and III

C. I and IV

**Explanation:**Trailing P/E = (1 - b) (1 + g) / (r - g). Note that b is the earnings retention ratio, not the payout ratio ( 1 - b).

g = ROE x b.

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**User Contributed Comments**
6

User |
Comment |
---|---|

volkovv |
A is a better choice here than B. If you just judge buy the formula of trailing P/E, when earnings retention (b) increases, dividend payout (1-b) decreases and at a first glance that will lead to a lower P/E (answer B) However, if you look one step further. When earnings retention (b) increases, g will also increase (g=b*ROE) and higher g well decrease denominator (r-g) in trailing P/E and in most cases (assuming that ROE>r) this will dominate decrease in dividend payout (1-b) in numerator and will lead to higher trailing P/E. Same logic can be applied to increase in dividend payout (1-b increases, b decreases, g decreases, r-g increases, trailing P/E decreases). And that makes I and III correct. |

bmeisner |
That's right. If you change b you change g and g has a greater influence on the justified P/E. E.g., if b1=50% and b2=70% then with ROE=20%, g1=10% and g2=14%. If r=20% then P/E1=5.5 while P/E2=5.7 Thus dividend payout decreasing means P/E increasing and vice versa. |

tim2 |
So if you don't pay out any earnings then the formula gives the P/E as zero. Seems to me that as the retention ratio goes to 100% PE goes down according to their stupid formula hence it should be I. |

somk |
these questions demonstrate that those who adapt themselves to life (regardless if right or wrong) do better than those who identify wrong thigs as wrong things. bmeisner, u'll do well n life; tim2 you'll fail. financially though, bmeisner u'll loose most of your active investment and u wont know why. tim2, u'll do great |

DariSH |
dividend payout is 1-b. So, if it increases, the P/E also increases. The question is - would the P/E descrease if ... increases. #1 is clearly wrong! |

akirchner1 |
I got B (II & III) for this one by plugging in numbers in the formula using Excel. |