Q:

Which of the following statements 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 the P/E ratio.

 

 

RELATED FAQS

  1. Under a pegged exchange rate system which of the following measures can be undertaken ...

    The correct answer is: a) By reducing the level of real interest rates at home, foreign and domestic investors will invest ...
  2. Which statement(s) is/are FALSE about market risk?

    I. It is mitigated by writing calls.II. It includes the risk the investor will lose invested principal.III. It is the same ...
  3. What's the difference between absolute P/E ratio and relative P/E ratio?

    The simple answer to this question is that absolute P/E, which is the most quoted of the two ratios, is the price of a stock ...
  4. If a person's account is frozen, which of the following activities is allowed ... ...

    The correct answer is a A frozen account does not mean that the person can not trade, it means that transactions must be ...
  5. 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 ...
  6. 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 ...
RELATED TERMS
  1. Price-Earnings Ratio - P/E Ratio

    The Price-to-Earnings Ratio or P/E ratio is a ratio for valuing ...
  2. Forward Price To Earnings - Forward P/E

    A measure of the price-to-earnings ratio (P/E) using forecasted ...
  3. Price/Earnings To Growth - PEG Ratio

    Price/Earnings to Growth (PEG) is a stock's price to earnings ...
  4. Horizontal Skew

    The difference in implied volatility (IV) across options with ...
  5. Franchise Factor

    The measurement of the impact on a company's price-earnings (P/E) ...
  6. Rule Of 18

    A rule whereby the sum of the inflation rate and the P/E ratio ...
Trading Center