Q:
A:
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.
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)/(kg)
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 Tbill 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.
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)/(kg)
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 Tbill 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
MORE FAQS

Which of the following statements is (are) true with respect to priceearnings (P/E) multiples ...

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

What is an alternative ratio to forward p/e?

How do I calculate the P/E ratio of a company?

What does it mean if a bond has a zero coupon rate?

What is the difference between forward p/e and trailing p/e?

How can I find the P/E ratio on an ETF's underlying index?

What is the average pricetoearnings ratio in the oil & gas drilling sector?

Where can I find the P/E ratios for the Dow and S&P 500?

What is the average pricetoearnings ratio in the drugs sector?

What is the average pricetoearnings ratio in the automotive sector?

What is the average pricetoearnings ratio in the food and beverage sector?

What pricetoearnings ratio is average in the aerospace sector?

Can a stock have a negative pricetoearnings (P/E) ratio?

Why are P/E ratios generally higher during times of low inflation?

How many attempts at each CFA exam is a candidate permitted?

Do financial advisors need to pass the Series 7 exam?

Do financial advisors need to be approved by FINRA?

How does a broker decide which customers are eligible to open a margin account?

Why is the Nasdaq more heavily weighted to tech stocks than other stock exchanges?
RELATED FAQS

Which of the following statements is (are) true with respect to priceearnings (P/E) ...
The correct answer is: b) The reason choice I is true is because during a recession, corporate earnings will generally fall ... 
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 ... 
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 ... 
How do I calculate the P/E ratio of a company?
The P/E ratio is a valuation measure that compares the level of stock prices to the level of corporate profits, providing ... 
What does it mean if a bond has a zero coupon rate?
Learn what the average range for the price to earnings (P/E) ratio in the electronics sector is and which factors influence ... 
What is the difference between forward p/e and trailing p/e?
Understand the difference between the trailing P/E ratio, which is the standard pricetoearnings calculation, and the forward ...
RELATED TERMS

Earnings Yield
The earnings per share for the most recent 12month period divided ... 
Forward Price To Earnings  Forward P/E
A measure of the pricetoearnings ratio (P/E) using forecasted ... 
Trailing PriceToEarnings  Trailing P/E
The sum of a company's pricetoearnings, calculated by taking ... 
P/E 10 Ratio
A valuation measure, generally applied to broad equity indices, ... 
Constant Maturity
An adjustment for equivalent maturity, used by the Federal Reserve ... 
Ratio Analysis
A ratio analysis is a quantitative analysis of information contained ...