Question #104

of 140 The Farmer Co. has a payout ratio of 65% and a return on equity (ROE) of 16% (assume that this is expected ROE for the upcoming year). What will be the appropriate price-to-book value (PBV) based on return differential if the expected growth rate in dividends is 5.6% and the required rate of return is 13%? A) 1.41. B) 0.71. C) 1.48. Analysts and portfolio managers at Big Picture Investments are having their weekly investment meeting. CEO Bob Powell, CFA, believes the firm's portfolios are too heavily weighted toward growth stocks. "I expect value to make a comeback over the next 12 months. We need to get more value stocks in the Big Picture portfolios." Four of Powell's analysts, all of whom hold the CFA charter, were at the meeting – Laura Barnes, Chester Lincoln, Zelda Marks, and Thaddeus Bosley. Powell suggested Big Picture should start selecting stocks with the lowest price-to-earnings (P/E) multiples. Here are the analysts' comments: Barnes said numerous academic studies have shown that low P/E stocks tend to outperform those with high P/Es. She uses the P/E ratio as the basis of most of her valuation analysis. Lincoln warned against using P/E ratios to evaluate technology stocks. He suggests using price-to-book (P/B) ratios instead, because they are useful for explaining long-term stock returns. Bosley prefers the price/sales (P/S) ratio and the earnings yield. Marks acknowledges that the P/E ratio is a useful valuation measurement. However, she prefers using the price/free-cash-flow ratio. Powell has provided Barnes with a group of small-cap stocks to analyze. The stocks come from a variety of different sectors and have widely different financial structures and growth profiles. She has been asked to determine which of these stocks represent attractive values. She is considering four possible methods for the job: The PEG ratio, because it corrects for risk if the stocks have similar expected returns. Comparing P/E ratios to the average stock in the Russell 2000 Index, because the benchmark should serve as a good proxy for the average small-cap stock valuation. Comparing P/E ratios to the median stock in the Russell 2000 Index, because outliers can skew the average P/E upward. The P/S ratio, because it works well for companies in different stages of the business cycle.