Question #17
Reading: Reading 22 Market-Based Valuation - Price and Enterprise Value Multiples
PDF File: Reading 22 Market-Based Valuation - Price and Enterprise Value Multiples.pdf
Page: 6
Status: Correct
Correct Answer: A
Question
At a CFA society function, Robert Chan comments to Li Chiao that the expected dividend growth rate for Xanedu Industries has decreased 0.5% from 6.0% to 5.5%. Chan claims that since Xanedu will maintain their historic dividend payout ratio of 40% and required return on equity (r) of 12%, Xanedu's justified leading P/E ratio based on forecasted fundamentals will also decrease by 0.5%. Is Chan correct?
Answer Choices:
A. No, Xanedu's justified leading P/E ratio will decrease by approximately 7.8%
B. No, Xanedu's justified leading P/E ratio will increase by approximately 7.8%
C. Yes, Xanedu's justified leading P/E ratio will increase by approximately 0.5%
Explanation
Chan is not correct. P/EXanedu = payout ratio / (r - g)
When the expected dividend growth is 6%, P/E = 0.40 / (0.12 - 0.06) = 6.67
When the expected dividend growth is 5.5%, P/E = 0.40 / (0.12 - 0.055) = 6.15
The percentage change is (6.15 / 6.67) - 1 = -7.80%, representing a 7.80% decrease.