If a firm has historically had a lower earnings multiplier than similar firms in its industry, which of the following factors could be responsible for this?
I. the firm has maintained a higher than average payout ratio.
II. the firm's profit margin is lower than average.
III. the firm's stock has a high financial risk.
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A. B. C. D. E.B
Recall the Dividend Discount Model formula: P/E = payout ratio/(k - g) in standard notation. From this formula, you may be misled into believing that increasing the payout ratio increases P/E. However, remember that g = ROE*(1-payout ratio). The more the firm pays out, the lower its growth rate is. Thus, it is not always necessary that P/E ratio will increase with increasing payout ratio. Indeed, in Walgreen's case, a low payout ratio was associated with low P/E.
If a firm has high financial risk, its required rate of return (k) is higher, depressing P/E.