Question #110
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: 37
Status: Unattempted
Correct Answer: A
Question
At a CFA society function, Andrew Caza comments to Nanda Dhople that the expected dividend growth rate (g) for Zeron Enterprises Inc (ZEI) is expected increase 0.5% from 6% to 6.5%. Caza claims that since ZEI will maintain their historic dividend payout ratio (g) of 50% and cost of equity (k) of 10%, ZEI's P/E ratio will also increase by 0.5%. Is Caza correct?
Answer Choices:
A. No, ZEI's P/E ratio will increase by approximately 14.32%
B. Yes, ZEI's P/E ratio will increase by approximately 0.5%
C. No, ZEI's P/E ratio will decrease by approximately 14.32%
Explanation
Caza is not correct. P/EZEI = payout ratio / (k - g)
When the expected dividend growth is 6%, P/E = 0.50 / (0.10 - 0.06) = 12.50
When the expected dividend growth is 6.5%, P/E = 0.50 / (0.10 - 0.065) = 14.29
The percentage change is (14.29 / 12.50) - 1 = 14.32%, representing a 14.32% increase.