Page 21 - FINAL CFA SLIDES DECEMBER 2018 DAY 14

Session Unit 14:
49. Equity Valuation: Concepts and Basic Tools

Example: P/E based on fundamentals: A firm has an expected dividend payout ratio of 60%, a required rate of
return of 11%, and an expected dividend growth rate of 5%. Calculate the firm’s fundamental (justified) leading P/E
ratio.

If in the market this

was 16? And what
if it was 7?

tanties

Other things equal, the P/E ratio will increase with:
(1) a higher dividend pay-out rate, All 3 means a higher PE ratio is justified?

(2) a higher growth rate, or

(3) a lower required rate of return.

While higher dividends will increase firm value, a lower growth rate will decrease firm value. This
relationship is referred to as the dividend displacement of earnings. The net effect on firm value of

increasing the dividend pay-out ratio is ambiguous. As intuition would suggest, firms cannot
continually increase their P/Es or market values by increasing the dividend pay-out ratio. Otherwise,
all firms would have 100% pay-out ratios.

Note: Watch for the wording “other things equal” or

“other variables unchanged” in any exam questions
about the effect of changing one variable.