- CFA Exams
- CFA Level I Exam
- Study Session 13. Equity Investments (2)
- Reading 41. Equity Valuation: Concepts and Basic Tools
- Subject 2. Present Value Models: The Dividend Discount Model

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**CFA Practice Question**

An analyst gathered the following information about a company:

Current annual dividend per share (D0) paid on the company's common stock: $2.40

Required rate of return on the company's common stock: 15.0%

Expected constant growth rate in earnings and dividends: 8.0%

Current annual earnings per share (E0) reported: $6.00

Current annual dividend per share (D0) paid on the company's common stock: $2.40

Required rate of return on the company's common stock: 15.0%

Expected constant growth rate in earnings and dividends: 8.0%

If markets are in equilibrium, which of the following statements best describes the company's price-to- earnings (P/E) ratio? The company's P/E ratio based on the infinite-period dividend discount model (DDM) is ______

A. less than the company's trailing P/E ratio.

B. the same as the company's trailing P/E ratio.

C. greater than the company's trailing P/E ratio.

**Explanation:**The trailing P/E ratio is computed as the current stock price divided by the current or trailing 12-months' EPS. On the other hand, the P/E ratio based on the infinite-period dividend discount model is computed as (D/E) / (k - g).

If markets are in equilibrium, the price per share reflects the value determined by the constant growth dividend. Using the constant growth model, the stock's value is ($2.40)(1.08) / 0.07 = $37.03;

the trailing P/E = 37.03 / 6 = 6.17. The DDM P/E is the dividend payout ratio divided by k-g = 0.4 / 0.07 = 5.71. Another way of computing DDM P/E is: Current Market Price / Expected 12-month earnings: 37.03/(6.00 x 1.08) = 5.71.

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**User Contributed Comments**
3

User |
Comment |
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nmech1984 |
How the DDM P/E is calculated? I did not understand either way... Any help guys? |

milica818 |
the DDM P/E is simply stock price = DPR/k-g (a good way to figure out stock price if you're not given current dividend but instead given some variation of the retention ratio or dividend payout ratio. |

milica818 |
however, why do they divide $37.03 by 6? confused |