CFA Practice Question

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CFA Practice Question

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

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.

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:


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.
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