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

A 7year, 6% coupon callable bond is currently trading at 96.25. The ...
Free info on financial certification exams including study guides, exam questions, and much more! 
According to SEC Release IA1092, which of the following would NOT qualify as an ...
The correct answer is C). SEC Release IA1092 considers financial planners, pension consultants and sports and entertainment ... 
Your client, Todd, owns 100 shares HAT stock in his taxable stock portfolio ...
The correct answer is a): Since Todd owns the stock and expects another stagnant year ahead, he would employ a covered call ... 
An individual has started investments of $100/month into a spreadload ...
The correct answer is b. When a periodic payment (or contractural) plan company is organized as a spreadload company, it ...
 No results found.