Question of the Week

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.

Answer:

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