Which of the following statements is (are) true with respect to priceearnings (P/E) multiples?
I. During a recession, P/E multiples will generally increase.
II. As the growth prospects of a company increases, holding everything else constant, its P/E will also rise.
III. As the required rate of return expected from a company decreases, holding everything else constant, its P/E will also decrease.
IV. During a period of decreasing interest rates, P/E ratios will generally decrease, holding everything else constant.
A) I and IV only
B) I and II only
C) II, III and IV only
D) II and IV only
The correct answer is: b)
The reason choice I is true is because during a recession, corporate earnings will generally fall faster than their respective stock prices. Remember, the price of a stock is supposed to reflect all future cash flows. The earnings (which is the denominator) would only be reflective of the current recessionary environment. We can see how P/E multiples are affected by looking at the following:
First, we know that
P_{0} = 
D_{1} 
(k  g) 
To calculate P/E, simply divide both sides by Earnings (E):
P_{0} 
= 
D_{1}/E 
E 
(k  g) 
Where: k is the required rate of return, and
g is the growth rate in earnings and dividends.
Therefore, II is correct because as "g" increases, the denominator will get smaller and the whole term gets bigger. III is incorrect because when "k" drops, the denominator will get smaller and thus the whole term will get bigger. IV is incorrect because as interest rates decrease, investors will generally reduce their required rate of return. As we have seen, this will boost P/E ratios.
RELATED FAQS

Mike is a highly compensated employee of XYZ Company, his company has offered him ...
The correct answer is b): One of the most common types of nonqualified retirement plans is the deferred compensation plan. ... 
The Chairman of Bright Star Life and Casual had a meeting with his broker this afternoon ...
The correct answer is b) Insider trading would include information that is material and nonpublic. Certainly, a poor earnings ... 
Which of the following steps is inaccurate with respect to calculating a figure for ...
The correct answer is c. Depreciation is added back to net income only when calculating for cash flow. In the case of shareholder's ... 
An investor owns 100 shares of LKI at $58. He needs to limit his loss to 5 points ...
Free info on financial certification exams including study guides, exam questions, and much more!
 No results found.