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**CFA Practice Question**

The P/S ratio will increase if the ______ decreases.

II. profit margin

III. required rate of return

IV. earnings growth rate

I. dividend payout ratio

II. profit margin

III. required rate of return

IV. earnings growth rate

A. I, II and IV

B. III only

C. I and III

**Explanation:**P/S = Net Profit Margin (1 - b) (1 + g) / (r - g).

g = ROE x b.

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**User Contributed Comments**
12

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

mbuechs2 |
Here is why I is correct: g and b are dependent on each other. Hence a highly profitable firm (ROE > r) will increase its P/S by not paying dividends (which will increase g). |

volkovv |
I can be true if ROE>r. When payout decreases, retention (b) increases and that increases g (g=b*ROE). When g increases, denominator (r-g) decreases and that increases P/S. The assumption that ROE>r is very important, only in this case denominator effect (decrease because of higher g) will dominate numerator effect (increase because of higher dividend payout ratio, i.e. 1-b) and this will lead to higher P/S. |

dblueroom |
Thanks, this is a very good question. it's easy to overlook payout ratio's affect on growth. |

tim2 |
I think the answer is wrong. If the payout ratio (1-b) is decreased to zero then the P/S also goes to zero ie. decreases, not increases (according to their formula) So the answer should be B |

mishis |
tim2: p/s increases only if there is growth, meaning company must retain some earnings therefore payout ratio cannot be zero. their answer is correct. |

mishis |
hm, correction, b cannot be zero, so I guess assumption is that company pays dividends |

tim2 |
thinking about it it's a vague question - do them mean holding g constant? roe constant? is roe>r? |

gnacinka |
I think we should write the formula including all four symbols I II III IV just like in the answer and then answer the question changing one of them and keeping the rest constant. |

Hishy |
This is correct. If ROE = 11% E/S = 1/3 r = 10% b = 0.5 Then P/S = 3.907 But if b = 0.4 Then P/S = 3.729 So (1-b) is inversely related to P/S |

NIKKIZ |
I drafted an example and did not agree with 1. Assume the following: ROE (stable) 0.0625 Profit Margin (stable) 0.10 Required Rtn (stable) 0.10 Initial Growth (variable) 0.05 b (variable) initially 0.20 Initally: ROE=g/b; 0.0625 = 0.05/0.8 (Profit Margin x 1-b x 1+g)/(r-g); (0.10x1-0.8x1.05)/(0.10-0.05) = 0.42 Thereafter, b increases to 0.9 Therefore g=bxROE; 0.05625=0.9x0.0625 New situation as follows: (0.1x1-0.9x1.05625)/(0.1-0.05625)=0.2414 Therefore with a higher retention rate we have a lower P/S ratio. The question did not state that the company was highly profitable, nor that g should exceed ROE. |

somk |
totally disagree. without specific numbers, we cant generalize. if payout ratio is 100%, P/S= 1/r; if payout is 0%, P/S=0. so P/S increase if payout increase. true, there are conditions where the effect of bXROE exceed the effect of (1-b) but we cant generalize. and for those who try to justify things by baseless arguments (b cant be zero, g cant be Grande skimi late, ROE cant be extra cheese), plz stop confusing the heck out of us. we're already overwhelmed. |

cminor |
Tricky. I like this one. |