Which of the following events would cause an increase in a firm's P/E ratio, assuming that everything else is held constant?
a) An increase in the Treasury bill yield.
b) A drop in the growth rate of earnings.
c) A drop in the Treasury bill yield.
d) A drop in the dividend payout ratio of the firm.
The correct answer is: c)
The constant growth rate model is as follows:
P = D1/(k - g)
Therefore, by dividing both side by earnings (E), we get:
P/E = (D1/E)/(k-g)
As the risk free rate of return (or the Treasury bill yield) decreases, investors will begin to require a lower rate of return on all other investments. (This is because the T-bill yield serves as a benchmark for the required return on all investments). However, as the required rate of return (k) decreases, the whole of the right side of the equation increases, and therefore, the left side (PE) must increase as well.
CFA Level 1 2005 LOS: 14.1.A.g and h, 14.1.B.b


  1. Which of the following statements is (are) true with respect to price-earnings (P/E) ...

    The correct answer is: b) The reason choice I is true is because during a recession, corporate earnings will generally fall ...
  2. What is the average price-to-earnings ratio in the banking sector?

    Explore the price/earnings ratio in regard to the banking industry and learn what the average P/E ratio is for most banking ...
  3. How do I calculate the P/E ratio of a company?

    Find out how to calculate this common valuation ratio and what the results can tell you about a company's performance.
  4. What does the forward p/e indicate about a company?

    Explore the forward price to earnings ratio and learn its significance and how it compares to the traditional price to earnings ...
  5. How can the price-to-earnings (P/E) ratio mislead investors?

    A low P/E ratio doesn't automatically mean a stock is undervalued, just like a high P/E ratio doesn't necessarily mean it ...
  6. What is an alternative ratio to forward p/e?

    Discover the most commonly used alternative equity evaluation ratio to the forward P/E ratio, and the relative advantages ...
  1. Earnings Yield

    The earnings per share for the most recent 12-month period divided ...
  2. P/E 30 Ratio

    The price-to-earnings (P/E) ratio is the valuation ratio of a ...
  3. P/E 10 Ratio

    A valuation measure, generally applied to broad equity indices, ...
  4. Gordon Growth Model

    A model for determining the intrinsic value of a stock, based ...
  5. Price/Earnings To Growth - PEG Ratio

    Price/Earnings to Growth (PEG) is a stock's price to earnings ...
  6. Constant Maturity

    An adjustment for equivalent maturity, used by the Federal Reserve ...
Trading Center