CFA Level 1: Earnings Multiplier Model - P/E Ratio Calculation

Calculate P/E Ratio Using the Earnings Multiplier Model

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Question

Given that the expected dividend payout ratio on a common stock is 0.65, the required rate of return is 15%, and the dividend growth rate is 6%, using the earnings multiplier model, what is the P/E ratio?

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A. B. C. D. E.

D

The infinite period Dividend Discount Model claims that the current price of a common stock is equal to D1 / (k - g), where D1 is next period's (most often next year's) dividend, k is the required rate of return, and g is the growth rate of dividends. The earnings multiplier model goes a step further by dividing both sides of the infinite period Dividend Discount Model equation by expected earnings during the next 12 months, yielding P/E = (D1/E) / (k - g). In this question, the P/E ratio is equal to 0.65 / (0.15 - 0.06) = 7.22.

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