Q:

Which of the following statements is (are) true with respect to price-earnings (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

A:

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

P0 =
D1
(k - g)

To calculate P/E, simply divide both sides by Earnings (E):

P0
=
D1/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.


MORE FAQS

  1. Which of the following statements is (are) true with respect to setting the proper constraints in managing ...

  2. Which of the following statements is (are) true with respect to the calculation of returns of composites ...

  3. A margin account has a long market value of $12,000, a debit balance of -$6,000 ...

  4. Which of the following signatures are required on a client’s new account form ...

  5. Which of the following events would cause an increase in a firm's P/E ratio ...

  6. Which of the following statements is(are) true with respect to the factors that a manager must take ...

  7. Which of the following are tools that are employed by the Federal Reserve in its efforts to control the money supply?

  8. Federal covered securities are subject to which of the following requirements ...

  9. Under the Uniform Securities Act, which of the following are defined as securities ...

  10. What two components are used to calculate risk-adjusted return? I ...

  11. Which of the following strategies is (are) appropriate? I. If a borrower has a fixed rate debt and is ...

  12. Under the Uniform Securities Act, registration with the Administrator as an investment adviser is required ...

  13. Which of the following deliveries for a 600 share order, broker-dealer to broker-dealer ...

  14. Which statement(s) is/are FALSE about market risk?

  15. If a sales representative moves from one broker-dealer to another ...

  16. In the separate account of a variable annuity, which of the following characteristics apply to annuity ...

  17. Money laundering has become a specific concern in all legitimate financial institutions worldwide ...

  18. If a person's account is frozen, which of the following activities is allowed ...

  19. ABC Broker-dealer has no office in state and transacts fewer than five trades during a 12-month period

  20. What does the forward p/e indicate about a company?

RELATED FAQS

  1. Which of the following statements is (are) true with respect to setting the proper ...

    The correct answer is: d) Choice II is incorrect because the longer the investment horizon, the less emphasis must be placed ...
  2. Which of the following statements is (are) true with respect to the calculation ...

    The correct answer is: a) (I) is incorrect because results that cover a period of less than a year must "not" be annualized. ...
  3. A margin account has a long market value of $12,000, a debit balance of -$6,000 ...

    The correct answer is a. I is correct since the stock's currently valued at $12,000 are increasing 20% or $2,400. II is incorrect ...
  4. Which of the following signatures are required on a client’s new account form ... ...

    The correct answer is B. While local practices of a broker-dealer might require the client to sign the form, even when opening ...
  5. Which of the following events would cause an increase in a firm's P/E ratio ... ...

    The correct answer is: c) The constant growth rate model is as follows: P = D1/(k - g) Therefore, by dividing both side by ...
  6. Which of the following statements is(are) true with respect to the factors that ...

    The correct answer is: c) (I) is incorrect because while he amount of new underwriting business that may be undertaken is ...
RELATED TERMS
  1. P/E 30 Ratio

    The price-to-earnings (P/E) ratio is the valuation ratio of a ...
  2. Horizontal Skew

    The difference in implied volatility (IV) across options with ...
  3. P/E 10 Ratio

    A valuation measure, generally applied to broad equity indices, ...
  4. Rule Of 18

    A rule whereby the sum of the inflation rate and the P/E ratio ...
  5. Franchise Factor

    The measurement of the impact on a company's price-earnings (P/E) ...
  6. Enterprise Multiple

    A ratio used to determine the value of a company. The enterprise ...
Hot Definitions
  1. Goldilocks Economy

    An economy that is not so hot that it causes inflation, and not so cold that it causes a recession. This term is used to ...
  2. White Squire

    Very similar to a "white knight", but instead of purchasing a majority interest, the squire purchases a lesser interest in ...
  3. MACD Technical Indicator

    Moving Average Convergence Divergence (or MACD) is a trend-following momentum indicator that shows the relationship between ...
  4. Over-The-Counter - OTC

    Over-The-Counter (or OTC) is a security traded in some context other than on a formal exchange such as the NYSE, TSX, AMEX, ...
  5. Quarter - Q1, Q2, Q3, Q4

    A three-month period on a financial calendar that acts as a basis for the reporting of earnings and the paying of dividends.
  6. Weighted Average Cost Of Capital - WACC

    Weighted average cost of capital (WACC) is a calculation of a firm's cost of capital in which each category of capital is ...
Trading Center